Interest-only mortgages: approach with caution

At the last count in late 2022, there were around a million borrowers on interest-only deals (apart from the buy-to-let sector, where interest-only is standard arrangement, and makes sense given the landlord can sell their investment at the end of the term and does not have to live in it), down from two million in 2015. This was a quicker reduction in numbers than the FCA had expected, and suggested those borrowers had robust repayment strategies or were able to remortgage on to repayment-type arrangements. But with interest rates rising over the past 18 months, the worry is that more existing interest-only borrowers may be stuck where they are.

So now feels like a good time for a refresher on why advisers should approach interest-only mortgages with caution.

First, a reminder of what interest-only mortgages are, and where they came from.

A brief history of interest-only

In the 1980s and early 1990s, most mortgage borrowers took out an interest-only loan, so-called because their monthly mortgage repayment consisted solely of the interest they owed that month on the capital they had borrowed from the mortgage lender. The borrower also made a monthly payment into an investment fund, usually an endowment policy. The idea was that the endowment policy, invested in the stock market, would generate enough money to pay off the outstanding capital debt at the end of the 25-year mortgage term (such as it generally was then) – and hopefully leave a lump sum left over for the homeowner to enjoy.

This was great news while sun shone – homeowners were happy, as were mortgage advisers, who earned commission on selling endowments. But when stock markets fell, as they do, many borrowers found themselves coming to the end of the mortgage term without sufficient capital to pay off their debt. Many borrowers claimed the risks had not been explained to them and they had been mis-sold their endowments. Thousands received compensation. Endowment policies became very unpopular.

But lenders continued to offer interest-only mortgages, and many borrowers carried on using them, as a cheaper alternative to a repayment-type (also known as capital-and-interest) mortgage. With rising house prices, many homeowners calculated that they should easily be able to pay off their capital debt at the end of the mortgage term, with enough left over for a smaller property. Others expected to pay off the debt using a future inheritance. And while these strategies worked for some, they have not worked for all.

Some borrowers have found themselves needing to remortgage and take equity out of their property over the years in times of financial pressure, meaning there is insufficient left to pay off their loan at the end. Others may not have received the inheritance they were anticipating.

When mortgage regulation was introduced in 2004, lenders were required to spell out to borrowers, taking out interest-only loans that they would need to find a way pay off the capital at the end of the mortgage term, and annual borrower communication letters had to reinforce the message. But only after the implementation of the Mortgage Market Review in 2014 were lenders required to assess affordability on whether the borrower could afford to repay their loan on a repayment-type (capital and interest) basis, not just an interest-only basis, and lenders were obliged to insist that interest-only borrowers had a clear strategy in place for repaying the loan.

Fast forward to 2024

With encouragement and assistance from mortgage advisers and lenders, many interest-only mortgage borrowers have successfully switched to repayment or managed to pay off their loan since 2014. But as mentioned at the top of the blog, there were still almost a million borrowers on these deals in 2022 – 750,000 on pure interest-only and 245,000 with part of their mortgage on an interest-only basis and part on repayment. The worry is that this number may be growing. With a combination of rapidly rising interest rates and the cost of living crisis, interest-only mortgages with their lower monthly payments look more appealing than ever.

Very few first-time buyers would qualify for an interest-only mortgage these days, but many existing borrowers forced to remortgage from a very low interest rate onto a much higher one in the last 18 months may well have been tempted to switch to interest-only as a temporary measure, hoping to switch back to repayment once rates come down in a few years’ time.

In the short term, this might look like a sensible financial plan. In some select cases, where a borrower’s circumstances have changed dramatically, it might be the only option. But wherever possible, sticking to a repayment-type mortgage is hands-down the safest choice for mortgage borrowers. It is all too easy to get lulled into the false security of an interest-only mortgage and kick the can down the road when it comes to paying off the capital – until you run out of road.

Interest-only may be a sensible alternative for niche borrower types in very particular circumstances. But for the majority, borrowing on an interest-only basis means potentially borrowing for longer, which means more total debt, or runs the risk of genuine future hardship. Worst case scenario: if you have to sell your home at the end of the term to pay off your mortgage lender and have no other funds, where are you going to live?

So every discussion an adviser has with a borrower who is considering an interest-only mortgage must be thorough, detailed and honest. A residential mortgage is unlike any other financial product in that it is a loan on a home, and there is no room for risk when it comes to the roof over a person’s head. A repayment mortgage is the best way to secure that finance – and your client’s future.