Lenders cut back on interest-only loans
The few remaining will have a premium, says Chiara Cavaglieri
Sunday 30 May 2010
Interest-only mortgages are being phased out as some of the biggest UK lenders raise rates and tighten restrictions. It makes financing a property purchase even more difficult for the self-employed and those without a regular wage.
Last week, Halifax added a 0.2 per cent premium to all its interest-only mortgages. Additionally, the bank cut the maximum amount it is willing to lend interest only from £1m to £500,000.
"This is simply a hedging manoeuvre against a higher risk and greater probability of customers defaulting. Given the credit crunch and the fallout from the property boom, this is a case of the bank closing the stable door after the horse has bolted," says Darren Cook from comparison site Moneyfacts.co.uk.
The lender announced in March and April that it would charge an extra 0.2 per cent for its interest-only trackers and fixed-rate mortgages, but this was only for customers going through a broker. It has now split its direct mortgage range too, meaning that borrowers looking for maximum loan-to-value (LTV) ratio of 75 per cent on a two-year fixed rate will pay 4.29 per cent for capital repayment, but 4.49 per cent for interest-only.
Many lenders pulled out of the interest-only market after the credit crunch, including Britannia, Clydesdale Bank, Scottish Widows Bank and Yorkshire Bank. Others are expected to review their current interest-only products and Santander has already cut the LTV ratio on its range from 85 per cent to 75 per cent.
"Given that the Halifax is a major lender, it is quite possible that other lenders may follow its lead of differential pricing over the course of the next few months," says David Black, banking expert for analyst Defaqto.
The big pull with an interest-only mortgage is that borrowers can expect substantially lower monthly payments because they are paying off only the interest, not the capital. So, with an interest of 2.5 per cent, for example, a £150,000 interest-only mortgage would cost £312.50, compared with £678.45 on a capital and interest repayment deal. What's more, when interest rates fell from 5 to 0.5 per cent at the beginning of the recession many people on interest-only mortgages which tracked the Bank of England base rate benefited hugely as their monthly payments fell to almost nothing. The danger is, though, that facing tough economic times, borrowers decided to pocket the money they were saving due to low rates rather than using it either towards paying off the capital or to invest in an Individual Savings Account to be used ultimately to pay off the home loan.
At the height of their popularity in the 1980s and 1990s, interest-only mortgages were often sold with endowment policies – an investment plan designed to run beside the mortgage and eventually clear the debt. The endowment mis-selling scandal seemed to put paid to this, but during the property boom of the 2000s interest-only once again became the mortgage of choice, this time for buy-to-let investors and hard-pressed first-time buyers, many of whom are gambling on a rise in their property price.
The property price falls of 2008 and 2009 highlighted just how risky a strategy this can be, leaving many with debts far bigger than the value of their homes. "The danger is that people begin to rely on this level of repayment, and never build up any equity in their home. This can make it hard to remortgage in the future, something many interest-only borrowers will be finding out now," says Hannah-Mercedes Skenfield from comparison site Moneysupermarket.com.
With borrowers struggling to meet payments and lenders keen to avoid risky lending, it may come as no surprise that these mortgages are becoming more difficult and expensive. The Financial Services Authority (FSA) itself has clamped down on interest-only deals. and as part of its mortgage market review proposals last year called for tougher lending criteria on this type of loan. As a result, lenders will argue that loading on extra charges for interest only is simply part of a new approach to responsible lending.
"It can be argued that a long-term interest-only arrangement goes against the principles of responsible lending. It may get the bigger house that you wanted but there is no room to manoeuvre if the borrower gets into temporary financial difficulty and the bank has no remedial option," says Mr Cook.
However, there will be some responsible borrowers who stand to lose out. Those who work and receive annual bonuses, for example, may prefer to pay only the interest on their home loan and use a cash lump sum to clear chunks of their debt as and when they can. Similarly, self-employed homeowners may rely on the flexibility of their interest-only mortgage to pay off their mortgage in accordance with their income fluctuations.
Interest-only mortgages are also the only way that many first-time buyers can get a foot on the housing ladder. As long as they switch to a repayment mortgage as soon as they can, it may be preferable to not getting finance at all. And if property prices go up they can use the equity to pay off their mortgage and take that next step on the ladder. Among the best buys for those looking to borrow at 70 per cent LTV, HSBC offers an interest-only loan for 2.49 per cent, fixed until 31 August 2012, with a £999 fee. For anyone with only a 10 per cent deposit, there is a huge jump in interest rates, with the best buy from the Post Office at 5.45 per cent, fixed until 31 July 2012, also with a £999 fee.
Notwithstanding, an interest-only mortgage should not be a long-term solution for most borrowers, and the temptation of lower payments may put some off switching to a repayment deal for longer than is necessary.
"For those on an interest-only mortgage, it is imperative you do not rest on your laurels. As soon as you can afford to move on to capital repayments, you should do so," says Ms Skenfield.
David Black, Defaqto
Back in the 1980s, interest-only mortgages were routinely subject to higher interest rates than capital repayment mortgages. Now it is happening again, with Halifax's 0.2 per cent premium on interest-only mortgages.
Capital repayment mortgages provide greater certainty and security for the borrower and the lender. Interest-only mortgages need a separate repayment vehicle and the dangers are that the underlying investment performance may not be sufficient. In hard times, the monthly investment may be one of the first outgoings to be dropped. A capital repayment mortgage should also help people avoid taking mortgage debt into retirement.
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