Interest-only loans: are they worth the gamble?

Is talking out an interest-only mortgage a bold move or a bad move? Industry figures reveal a rise in the number of homebuyers turning to interest-only loans again, after years of declining interest. Figures from the Council of Mortgage Lenders (CML) show that the number of interest-only first-time-buyer mortgages has crept up by 5 per cent over the last two years, while broker My Mortgage Direct says that 35 per cent of its clients have opted for interest-only over the last year.

The revival comes largely from borrowers who are attempting to cut costs by switching to interest-only in the hope that future house price rises will rescue them from their mortgage debt. As the name interest-only implies, borrowers pay only the interest on their loan each month. Their repayments make no inroads into the original loan, which must be repaid somehow at the end of the mortgage term.

The monthly savings made by opting for interest-only can be substantial. According to David Hollingworth of Bath-based broker London & Country, a typical 25-year £100,000 interest-only mortgage at 5 per cent costs £416 a month compared to nearer £585 a month for a repayment deal (where the capital as well as the interest is repaid). Over the life of the loan, a borrower pays £125,000 in interest on the interest-only deal - but only £75,377 on the repayment loan. This is, of course, something that borrowers might care to consider before opting for interest-only.

Although borrowers are not obliged to take out a savings plan at the same time as their loan, they need to consider how the loan will eventually be repaid. 'The high volume of remortgaging in recent years has made it harder for lenders to keep track of repayment vehicles so the onus has switched from the lender to the borrower to make sure these are in place,' says Bernard Clarke, spokesperson for the CML.

While some are gambling on house price increases to save them, others are pinning their hopes on a lump sum such as an inheritance. In the 1980s, borrowers routinely took out endowment plans alongside interest-only mortgages. They were often lured by commission-driven salesmen who suggested endowments were a one-way bet for borrowers. Not only would an endowment grow strongly enough to pay off their mortgage, they said, but more than likely provide them with a tidy lump sum on top.

These misinformed promises led to a boom in sales, with endowment mortgages accounting for 88 per cent of all loans in the second quarter of 1988 and repayment loans representing only 10 per cent, according to figures from the CML. With endowments now discredited, repayment loans account for 83 per cent of first-time buyer deals, compared with 17 per cent for interest-only (only one per cent of these are endowment-backed).

Repayment loans are a safer bet, even though they cost about a third more in monthly repayments, because they guarantee that the original loan will be repaid by the end of the term. Nevertheless, interest-only deals are starting to creep back. This reversal of fortunes is partly due to the boom in buy-to-let. Landlords tend to prefer interest-only as they are likely to sell within a few years - plus only the interest element of their mortgage repayments can be offset against their rental income.

But a more significant influence is probably the rise in bank interest rates, combined with high property prices. Many first-time buyers find interest-only is the only method of affording their first home.

Melanie Bien, director of Savills Private Finance, a London-based mortgage broker, says: 'Interest-only deals have long been popular among high net worth clients as they intend to clear the debt well before the end of the term. They also rely on bonuses to whittle away at the outstanding loan.'

For first-time buyers and homebuyers of more modest means, interest-only deals are a riskier prospect. Bien says: 'Plenty of buyers still opt for interest-only because it means they can afford the repayments more easily on a big mortgage than they would with a repayment deal, and while they should have an investment vehicle of some sort, many of them don't bother.

'While this can help many people on to the property ladder who couldn't otherwise afford it, our advice is to be very careful on this as you are gambling with the roof over your head. If you are paying less than you should be - by not bothering with an investment vehicle - you are going to get into trouble at some point.'

Interest-only deals can be useful if managed correctly. Bien adds: 'A number of lenders will allow a first-time buyer to pay only the interest for the first couple of years, reverting to a repayment loan after this period. This means the borrower benefits from lower repayments when money is tight but still manages to pay the entire mortgage off by the end of the term. Borrowers do need to prepare themselves for a big jump in their mortgage costs once they switch from interest-only to repayment.'

Borrowers following a defined upward career path - with a rising income to match - can also afford to take some risk. It can also save homebuyers money by enabling them to buy a bigger property that they will not outgrow too quickly.

Colin Dale, head of lending at Skipton building society, says he has seen a marked growth in the number of people taking interest-only loans recently to secure cheaper monthly repayments, concentrated mainly in the south east. But he has also witnessed a pattern of switching to interest-only among older borrowers. Dale says: 'Usually they do this to raise funds for their children in some way, such as helping them on to the housing ladder. This group at least knows they have equity in the property to repay the loan.'

Dale adds: 'Borrowers shouldn't rely on an increasing value of their home or the ability to trade down at a later date. If rates were to go up or house prices to go down, it is feasible that someone could end up with a debt they will never clear.'

Creeping costs

Costs are silently creeping up in the world of mortgages so homeowners, particularly first-time buyers who could be hit hardest, would do well to watch out for them. Ten days ago Halifax took the unusual step of increasing its early redemption charge - the penalty borrowers pay to exit from an offer period early. The early redemption charge on its two-year Home Mover tracker has risen from 2 per cent to 3 per cent. It has also increased the early exit fee on its remortgage tracker from 1 per cent to 2 per cent.

'This illustrates how important it is for borrowers to check the details of the mortgage they are taking out,' says Melanie Bien. 'It is also vital to ensure you don't take out a deal that ties you in for a longer period than you are entirely comfortable with; if in doubt opt for the shorter term and then remortgage again to another deal when it comes to an end.'

Halifax is by no means the only lender to increase charges recently. Since the new year at least half a dozen lenders have started to recoup money lost through low-cost mortgages and the expense of meeting regulation requirements. Mortgage broker Charcol says that fees have increased, on average, by 53 per cent since the start of 2004. Portman, for example, has increased its arrangement fees by £200 from £399 in early 2004 to £599 now. The Royal Bank of Scotland, The Woolwich, Abbey, Northern Rock and Cheltenham and Gloucester have also all increased their arrangement fees. Nationwide's booking fee went from £249 at the start of 2004 to £389 now.

While first-time buyers are the ones suffering from these introductory costs, existing homeowners have not been let off the hook. Alliance and Leicester has increased the fee it charges for transferring to another lender from £195 to £295. There is a substantial difference between this and what some other lenders charge. West Bromwich, for example, charges £70 and Norwich and Peterborough £75. 'Lenders should fix this fee from the outset - at the moment they are free to change it as and when they wish,' says Bien.