A memo to borrowers: tomorrow will come

Set up a savings plan to pay the loan on the property itself or you could be in trouble later, says Emma Lunn

Living for today with only half an eye on the future is something of which many of us are guilty. But if you take out an interest-only mortgage on a home without setting up a separate savings vehicle to pay for the property itself, you could wreak serious financial damage.

Living for today with only half an eye on the future is something of which many of us are guilty. But if you take out an interest-only mortgage on a home without setting up a separate savings vehicle to pay for the property itself, you could wreak serious financial damage.

Monthly payments on an interest-only home loan cover just that - and so are cheaper than repayment loans that both pay interest and chip away at the capital. For example, a £100,000 repayment deal at 4.75 per cent over 25 years would set you back around £570 a month. With interest-only, this drops to around £395, but at the end of the loan, customers must pay the lender the £100,000 for their house.

To do this, borrowers should have set up an individual savings account (ISA), savings plan or endowment that runs alongside the mortgage and is usually cashed in 25 years down the line.

The trouble is, not everyone is doing so. More than 250,000 borrowers have an interest-only deal that is not linked to an investment policy, according to a recent survey by the Office of the Deputy Prime Minister - and nearly 14,000 have no idea how they will clear the loan.

"If borrowers see interest-only simply as a way of cutting back on their monthly outgoings, and don't set up an investment vehicle, they are storing up trouble," warns Simon Jones, director at mortgage broker Savills Private Finance.

Borrowers should be told by lenders and brokers that they must make their own provision for this capital sum. And if they forget, annual mortgage statements will include a reminder note. However, many are relying instead on house price increases that will allow them to sell up and repay the loan years into the future. Others plan to switch to a repayment mortgage - usually for a small £50 to £60 fee - when their income has risen and they can afford it.

Such assumptions carry risks. "We advise people to have a plan, whether it's to start an ISA savings plan or to switch to a repayment mortgage at a set point in the future," says James Cotton of mortgage broker London & Country. "You need to think long and hard about how you're going to pay it back."

Although popular with first-time buyers due to the lower monthly payments, interest-only deals make more sense for buy-to-let investors - where the mortgage can be offset against rental income - or those who will be able to repay the capital later through, say, an anticipated inheritance.

For all that, though, 15 per cent of first-time buyers took out an interest-only mortgage in December 2004, compared with 12 per cent two years ago, according to figures from the Council of Mortgage Lenders. CML spokesman Bernard Clarke says these figures only represent a modest increase and plays down suggestions that the trend could lead to problems later on.

Edward Reid has always had an interest-only mortgage. The 46-year-old pays £500 a month on a two-year discounted interest-only £100,000 loan with Alliance & Leicester, on his five-bedroom house in Lincolnshire.

When the loan term ends in 12 years' time, he hopes to pay off the capital sum by trading down to a smaller house (his four children will have left home by then) and cashing in three endowment policies that are now in place. "Our circumstances will be totally different then, and I'll cross that bridge when I come to it."