Betting the house on a cheaper loan

Thousands of homebuyers with cheap interest-only mortgages do not know how they will pay off their loans when the terms end. One client of mortgage broker John Charcol planned to sell his vintage car to settle up.

But lenders, most of whom do not compel clients to set up arrangements to repay these loans, are beginning to acknowledge that these vulnerable borrowers have a problem.

They choose these loans because the monthly repayments can be significantly lower than for a traditional capital and interest or repayment loan, or one backed by an endowment policy, an individual savings account or a pension. Monthly payments for a £100,000 repayment mortgage at 7.5 per cent over 25 years will be around £750. The monthly outlay on an interest-only loan would be nearly £125 cheaper, at £625.

Ray Boulger of John Charcol says they can work well for highly paid people, typically City workers who receive large bonuses that pay off chunks of capital. They can also work well for young people, who expect their earnings to rise rapidly.

'You can take out the loan on a 25-year term, pay interest-only for two or three years and then put a repayment mortgage in place.'

He agrees, however, that interest-only is right only for those with a clear strategy for repaying the debt.

Mortgage broker Clive Miers says most of his clients are concerned about ensuring that they have a method of repayment in place. However, he is receiving an 'enormous' number of calls from people who have cancelled endowment policies because of fears that the insurance policies linked to their loans may not be enough to repay the debt.

Normally, cancellation is not advisable because of poor early-surrender values. Miers says those with the better-paying life insurers, such as Standard Life or Scottish Widows, may receive encashment values that contribute usefully to repaying the loan.

Those cutting their losses from endowments are putting the remainder of the mortgage on a repayment system, often choosing a flexible loan that allows lump-sum repayments. Whatever happens, Miers adds, borrowers cancelling policies should find other ways to repay the capital.

Another category of borrower who may be at risk with interest-only loans are those who took out personal equity plans instead of endowments. Peps were abolished more than a year ago and there are fears that many homeowners have put nothing in their place.

Lenders are already required by the Mortgage Code to put a warning notice on annual statements about repayment, but the industry was criticised by Which? magazine recently for failing to do enough to find out whether borrowers were making adequate repayment arrangements. The magazine questioned the 20 top lenders, and only Halifax, HSBC and the Royal Bank of Scotland were checking on clients' repayment methods before releasing loans.

The four lenders that made 'the least effort' to prevent borrowers being left with no means of repaying their loans were Alliance & Leicester, Bradford & Bingley building society; Cheltenham & Gloucester and Woolwich.

Which? pointed out that the Banking Ombudsman regularly receives complaints from people who belatedly discover that no endowment has been set up for their loans, even though they believed this had happened. Often this is due to administrative bungling.

Lenders are beginning to act. Some fear they will be blamed if a large number of elderly borrowers lose their homes in future because no one checked up on their plans for repayment.

Portman building society started a rolling programme of mailings to borrowers earlier this year asking whether they had repayment vehicles in place. The society says the initial response was disappointing, although replies have trickled in since.

Around 60 per cent of Portman's loans are interest-only.

Spokesman John Gully believes most of these bor rowers have some method of repayment in place. But it could be an endowment that will fall short, or an inadequate Isa savings account.

He warns: 'I have a feeling that people settle down with a mortgage, tuck a bit of money away but are not building up a fund big enough to repay the loan at the end of the term.'