Back in 2013, the FCA identified three residential interest-only mortgage maturity peaks. The first peak was back in 2018 and there are two more predicted for 2027-2028 and 2032. What’s more, interest-only mortgages are very much still available in the residential-mortgage market. In fact, the number of residential interest-only mortgage products available almost doubled between 2013 and 2019.
This raises the question of whether or not the “mortgage timebomb” can be diffused over the next decade or so or if it could tick on for longer. Of course with recent events and the raised interest in this product, the question is now very important.
A brief explanation of interest-only mortgages
With an interest-only mortgage, the borrower makes interest repayments over the course of the term and then repays the capital at the end of the term. On the one hand, this makes monthly repayments more affordable than they would be for a repayment mortgage for the same amount. On the other hand, it means that interest is always charged on the amount originally borrowed, rather than over an amount which is continually decreasing. It also means that the only equity borrowers build up in their home is via house-price inflation.
The challenge of paying back the principal
Mortgages, by definition, are secured loans. Specifically, they are loans secured against your home, which means that your home is always at risk if you are unable to make repayments as you should.
With repayment mortgages, however, you are, again by definition, repaying some of the loan principal each month. With interest-only mortgages, however, you have to find an alternative method of paying back the capital and the harsh reality is that even selling the property may not be enough to do so.
The issue of equity
As previously mentioned with an interest-only mortgage, the only equity you accumulated is through house-price inflation. This means that you would only be able to repay the loan capital purely through the sale of your home if you achieved a net profit at least equal to the amount you originally borrowed.
While this is certainly not out of the question at all, it depends both on the state of the housing market at the time and on the tax regime in force. For example, if the government does implement the suggestion of levying stamp duty on sellers rather than buyers, you would need to make enough profit to cover that.
Similar comments apply to using equity release. Even though equity release products do not typically require the borrower to make any repayments during their lifetime (unless they move into permanent care), there is still an expectation that the loan will be repaid, with interest, after their death (or move into permanent care), hence the loan-to-value ratio has to make that feasible.
Alternative repayment vehicles
Of course, selling the property is not necessarily the only way to repay an interest-only mortgage. You could use savings, investments or the proceeds from a pension pot, in fact, in theory you could use anything you wanted as long as it covered the cost. The challenge is that in a low-interest-rate environment, returns on cash deposits are uninspiring. It is, of course, possible for mortgage-holders to put their savings into higher-interest bonds, but the challenge would be to find bonds with high interest but low risks.
Similarly, investment returns are not guaranteed, which means that if the size of pension pot is dependent on investment returns, it is not guaranteed either.
The future of residential interest-only mortgages
In theory, the emphasis on affordability criteria, including having a realistic plan for paying back the loan principal, should protect both borrowers and lenders going forward. In practice, only time will tell if this is the case or if interest-only mortgages really need to be relegated to financial history.
Your property may be repossessed if you do not keep up repayments on your mortgage.
Equity release refers to home reversion plans and lifetime mortgages. To understand the features and risks ask for a personalised illustration.
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