One day will be payback time

Buyers need to think carefully before taking out an interest-only mortgage, says Stephen Pritchard

Opting for an interest-only mortgage has become a popular way to offset the high cost of stepping on to the property ladder.

Unlike a conventional repayment mortgage where the monthly bill includes both capital and interest, an interest-only mortgage leaves the debt untouched. It is up to the buyer to arrange a way to pay off the loan at the end of the mortgage term.

In 2005, a quarter of first-time buyers opted for either an interest-only mortgage or a mortgage that mixed interest-only and repayment; in 2004, the figure was just 15 per cent. Homebuyers are coming back to interest-only mortgages after a few years when they appeared to be out of fashion, following the endowment mortgage scandal.

Lower monthly payments are the main attraction, but mortgage lenders and the Financial Services Authority are starting to worry that too many homebuyers are taking out such loans without considering how they might repay the debt. Borrowers with interest-only mortgages are also more vulnerable to interest rate rises.

Why are there concerns about interest-only mortgages?

Lenders are worried that borrowers are opting for interest-only mortgages so that they can stretch their budgets. Although the monthly payments on an interest-only loan are lower, it is up to the borrower to set up an investment plan or other way of repaying the debt at the end of the mortgage term.

The suspicion is that many borrowers are not bothering to do this. "An increasing number of borrowers are opting for interest-only mortgages because monthly payments are cheaper than on a repayment deal," says Melanie Bien, associate director at mortgage brokers Savills Private Finance. "The danger is that they leave it is too late to make up the cash." If borrowers have not set up a way of repaying the mortgage, they could lose their property.

Also, because all of the monthly payments are interest rather than interest and capital, homeowners will see a proportionally bigger increase in their monthly outgoings, if interest rates rise. This will be all the more troublesome for buyers who have opted for interest-only loans because a repayment mortgage would have stretched their budget.

What about endowment mortgages?

The endowment mis-selling scandal, along with poor returns from stock markets, put an end to endowment policies as a popular way of repaying a mortgage. The scandal arose because homeowners' policies were no longer sufficient to pay off their loans. Homeowners had to switch their loans to capital repayment or top up their endowments.

What actions are lenders taking?

"The FSA has highlighted interest-only mortgages as one area they are looking at," says Ray Boulger, senior technical manager at mortgage brokers John Charcol.

Some lenders are reacting by restricting the mortgages they offer on an interest-only basis. At Savills Private Finance, Melanie Bien points out that the Norwich & Peterborough Building Society recently launched a 100 per cent mortgage. But it is only available on a repayment basis. "This underlines the fact that the lender is concerned about the amount of debt people are taking on with no thought as to how they are going to repay anything beyond the monthly interest."

So how do people repay their loans?

One option is to take out an interest-only mortgage initially, and then switch to a repayment loan when more cash is available. An alternative is to opt for a flexible mortgage on an interest-only basis, and set up capital repayments each month on top. This avoids the need to pay a fee to convert the loan to a repayment basis.

The important point, though, is to have a firm plan and not rely solely on selling the property.