Interest-only puts you on the ladder, but will it bring you crashing down?

'I'm sure the value of my home will rise'

First-time buyers could be forgiven for being a little over-optimistic when trying to get a foot on the housing ladder.

But those applying for a cheap interest-only mortgage who don't have a savings plan in place to pay off the capital in 25 years' time could run into trouble.

Ten days ago, Nationwide tightened its lending policy to ensure that applicants for mortgages make proper provision to cover the capital sum in the future. It insists they must now include full details of the repayment vehicle chosen to pay off the loan, one that should generate a large enough sum in the years to come.

Savings linked to an interest-only mortgage will typically be held in an individual savings account (ISA) or an existing personal equity plan (PEP). But even a tax-free cash chunk of your pension could suffice.

"If the details don't appear on the application, or the figures don't stack up, we can't issue a mortgage offer," says Nationwide's spokeswoman, Tamsin Hemsley.

It says this policy is a response to regulatory changes ushered in last year by the Financial Services Authority (FSA). The new rules insist lenders must ask the borrower for "evidence of intent" that the property's capital value will be paid off in the future.

But other lenders aren't so specific in setting out their lending criteria.

"Most lenders don't ask for proof of savings - and some don't even discuss repayment plans," says Melanie Bien of Savills Private Finance broker.

Nationwide's new rules mean you won't qualify for an interest-only loan if you plan on paying off the capital by relying on an inheritance, or on hopes of a future pay rise.

If you intend to save via bonuses invested in an ISA instead of making regular deposits, you may be required to show Nationwide some proof from your employer that a bonus system is in place.

If you're relying on selling the property in the future in order to pay off the capital, you won't qualify unless you already own a house with £150,000 worth of equity in it, and the mortgage you are applying for is less than 66 per cent loan-to-value. This, in effect, rules out first-time buyers.

However, Nationwide will look favourably on you if you plan to switch to a repayment mortgage in five years' time and will be paying into an equity ISA in the meantime. Nationwide won't be checking up on applicants to see if they're true to their word, though: borrowers could in theory make no provision during this time.

Interest-only loans have been popular with first-time buyers because of the lower initial monthly repayments, Ms Bien says.

She gives the following example: "Taking a 25-year interest-only mortgage of £120,000, at an interest rate of five per cent, costs £500 a month. But the same deal on a repayment basis costs £700 a month."

Ray Boulger, senior technical manager at the broker John Charcol, says that an interest-only deal can make financial sense on a temporary basis: "First-time buyers especially may have more expensive debt they want to clear first, and paying just the interest on the mortgage can enable them to do this.

"Once they have got rid of this debt, they can switch to a repayment loan."

More than a quarter of homeowners now pay for their property with an interest-only mortgage, according to research from Abbey. Of these, some 37 per cent aren't saving anything towards the capital.

Even if you intend to save religiously to pay off your mortgage, Ms Bien stresses that interest-only loans should be a last resort.

"Anyone considering an interest-only mortgage should be aware that whichever investment vehicle they opt for, it may not raise enough cash to pay back the capital at the end of the term," says Bien.

One solution is an interest-only loan that allows penalty-free overpayments. Here, you are not committed to paying a higher monthly sum but can pay in spare cash to whittle away at the capital.

Most lenders allow at least 10 per cent penalty-free overpayments per annum, but check before taking out the loan.

Justin Westcott, a 27-year-old public affairs manager, decided that it was more important to grab the first rung of the housing ladder than to worry about setting aside money to pay for a home in the future.

Two months ago, he bought his first property in Clapham, south London, with an interest-only mortgage from Northern Rock. He is paying a rate of 5.99 per cent and the deal is fixed for three years.

"I am not saving into any investment vehicle at the moment," he says, "but my main concern was getting on the housing ladder.

"The repayments cost me £870 a month, as it is. I've stretched myself to my maximum borrowing capacity - and that was with a 10 per cent deposit from my father."

At the end of the fixed-rate term, Justin intends either to switch to a repayment mortgage or keep the interest-only loan and start saving into an ISA.

"I have no grand plan," he says, "but I'm sure the equity in my home will rise by then - and I'm gambling my salary will go up too."

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