Cheap payments, but mind the catch

Last October, the BBC's Money Programme sent a shiver through the mortgage industry when it exposed abuses in the sale of self-certified mortgages. The programme showed mortgage advisers encouraging people to lie about their earnings to boost their borrowing power.

Warnings were sent out by the industry's regulator, and one lender, Cooperative Bank, pulled out of the market, while others have tightened up their act.

Soaring house prices have driven some consumers to desperate measures to get on to the property ladder. But what are the risks? One of the most common high-risk strategies is to take an interest-only mortgage, with no vehicle for repaying the loan. Ray Boulger, senior technical manager of London broker Charcol, says: 'In many cases [lenders] don't know what provisions the customer has made to repay the loan.'

At best, they must remind customers of the danger of not having the means to repay when they send out annual statements.

The reason why an interest-only mortgage can seem attractive is that monthly repayments are typically around 40 per cent less than on a repayment loan. Patrick Bunton of Bath broker London & Country says: 'This is particularly dangerous if you are borrowing a high proportion of the property's value, because if there were any correction to house prices you would be in negative equity straight away.'

At current low interest rates, repayment mortgages are far more effective at repaying capital in the early years than they used to be, he says, giving borrowers an effective slice of equity which would act as a buffer against any fall in property prices. Interest-only loans can make sense if you are a young, newly qualified professional with good expectations that your income will rise significantly in the next few years, says Bunton. 'In those circumstances, you may judge that money in your pocket today is worth more than it will be tomorrow, and you can convert to repayment in a few years' time.'

Expectation of a large inheritance can also be a reason for going the interest-only route. But Bunton cautions against taking an interest-only mortgage with the intention of down-sizing later. 'In practice people find a downward step is usually a last resort.'

A compromise is to take part of your loan as repayment and the rest interest-only; alternatively, as Boulger points out, most lenders will allow you to pay off up to 10 per cent of capital each year without penalty.

A second high-risk strategy is to shop around for the highest earnings multiple. These days there are few hard and fast rules about income multiples. Typically, lenders quote up to 3.5 times one person's earnings or 2.5-2.75 times joint earnings on a 95 per cent mortgage, but if you have a substantial deposit - 25 per cent or more - many lenders will advance up to five times one person's earnings, or not seek evidence of earnings.

The vital thing, stress the brokers, is to work out what you can really afford. 'Different people are comfortable with different multiples,' says Boulger. 'You might have two people on the same salary, but one has kids at private school and takes lots of holidays; the other is happy to put most of their disposable income into their mortgage repayments.'

The closer the monthly repayment is to what you can afford, says Boulger, the better the argument for taking a fixed rate, preferably for five years minimum. Even longer fixes are worth considering. The Cheshire building society is offering a 25-year fixed rate of 5.65 per cent, which can be redeemed after six years without penalty.

The real danger with getting a high multiple of your earnings is that interest rates will rise. As Bunton points out: 'If interest rates go up from 4 per cent to 5 per cent, it means your repayments have gone up by 25 per cent. Can you afford it?'

Finally, self-certified mortgages were designed primarily for self-employed people, who don't have pay-slips to show lenders, and whose accounts are often designed to minimise profits for tax purposes. They can, however, be suitable for people in salaried employment who have supplementary sources of income, such as firemen.

The important point, he warns, is not to delude yourself about what you can afford, and to remember that this type of mortgage typically comes at a cost: a higher mortgage rate plus, often, an arrangement fee.

The ultimate risk of over-stretching yourself is the possibility of higher interest rates together with a significant increase in unemployment and the return of negative equity. It happened at the end of the 1980s, and it's a brave person who believes it will never happen again.