Borrowers set up home in never-never land

First-time buyers and cash-strapped home owners are scrambling to take out interest-only mortgages that could leave them facing financial ruin or forced to trade down the property ladder to pay off their mortgage.

Mortgage lenders’ willingness to market interest-only home loans has prompted fears that these mortgages could be the cause of the next misselling scandal. Concerns about the rapid growth of this type of lending has led the Financial Services Authority to launch a review of the sector. It pinpointed interest-only mortgages as one of the top “emerging retail risks” and drew attention to “an increasing number of mortgages . . . with the lender not recording that there was a linked repayment vehicle in place”. It expects to report its findings in the new year.

The Financial Ombudsman Service says it has received 400 complaints about interest-only mortgages over the past year, a small increase on the year before. Some people complained that their lender had promised to put a repayment mechanism in place but had failed to do so. Others said the risks had not been made clear to them.

The Financial Services Consumer Panel’s latest annual report drew attention to “a worrying level of interest-only mortgage arrangements being made where the lender has no knowledge of how the capital would be repaid at the end of the mortgage term”.

Misunderstandings over what is being sold are frequent. “We were aware that people were scrambling on the housing high wire without a safety net,” says John Howard, chairman of the consumer panel. “They were only realising a few years down the line that they had not paid back what they borrowed. It is unfortunate that the word ‘mortgage’ is still used because that makes people think they are paying it off.”

Interest-only mortgages have proved popular with buy-to-let investors because they can set interest costs against rental income and, if they own several properties, they can sell one to meet repayments. “More sophisticated buyers with several properties can move their money about,” says Melanie Bien, associate director at Savills Private Finance.

But their enthusiastic take-up by first-time borrowers is what is worrying regulators and many people in the industry. Until the 1990s borrowers who took out an interest-only mortgage were required at the same time to make payments into a pension or endowment policy that would pay off the principal. This underpinned many home loans but some endowment mortgages undershot investment targets.

But increasing competition between lenders led to this requirement being dropped and 16 per cent of loans taken out by first-time buyers in July were interest-only with no repayment policy specified, according to the Council of Mortgage Lenders (CML). In these cases, borrowers could find themselves obliged to sell their homes to repay the original loan.

With the average first-time buyer now borrowing 3.21 times their salary, the highest figure ever, to get on the housing ladder, the pressure remains strong. First-time buyers pay on average £135,000 for their first home while the average national house price is around £220,000 – and even higher in London and the south-east.

The superficial appeal of an interest-only loan is clear. A £150,000 interest-only loan at 5 per cent would require a payment of £625 a month compared with £877 on a 25-year repayment mortgage. But, unlike the homeowner with a repayment mortgage, at the end of 25 years the interest-only borrower would still have debt of £150,000.

“This can be a good product for some people but they must understand what they are doing,” says the Building Societies Association. “People must understand that they have to pay the loan off and that they must have some mechanism in place. It is a good way for recent graduates, for example, to get on the housing ladder in the hope that they will get pay rises in the future.”

But many borrowers do not seem to be planning ahead. “Demand is higher than we would like,” says Paul Hearnden, director of My Mortgage Direct, a broker. “Between 30 and 40 per cent go for interest-only deals. The under-35s are absolutely unwilling to compromise on their lifestyle. They think the value of the property will go up or they will inherit some money. They forget that when they move, the moving costs, agent’s fees and stamp duty could eat up all the equity because they have not paid anything off.”

Fears that borrowing is getting out of hand have been stoked by the launch by Kent Reliance Building Society of an “intergenerational” or “endless mortgage” that can be rolled over to succeeding generations. The society says there has been an “exceptional” level of interest since it was offered in August although only a few have been sold so far.

Kent Reliance says it carries out “all the regulatory checks as with a normal mortgage” including a review with the customer after five years. It has also written to existing interest-only borrowers reminding them that the loan would need to be paid off and reminding them they could switch at no cost to a repayment mortgage.

The FSA does not require lenders to insist that borrowers put in place a repayment package but “we would expect lenders to have a record of the borrower’s ability to repay a loan. Without a repayment vehicle and with inflation eroding borrowings less than it used to this can become a millstone if people wake up to it late.”

Howard, the consumer panel chairman, says: “Some lenders have been robust and will only provide a loan if you can show an insurance policy or a pension product to pay it off. Others have been quite blasé about it.”

The Yorkshire Building Society says it does not require borrowers to prove they can repay but it does advise people to put in place a repayment policy. “We would not recommend [an interest-only mortgage] but it can be a useful tool. We have done other things to help first-time buyers including increasing the salary multiples we accept.”

In July the Britannia Building Society took action “to highlight solutions to this potential time bomb.” It scrapped charges for switching to a repayment mortgage and stepped up its communications with members.

“Warnings about setting up appropriate payment vehicles for interest-only mortgages were previously incorporated into annual mortgage statements but feedback from members showed these were overlooked,” it said. It has been contacting members to encourage them to take control of their debt.

Interest-only mortgages are even more popular with people moving home, according to the CML. In July, 22 per cent of home-movers took out this type of mortgage “with the repayment vehicle not specified” compared with 16 per cent of first-time buyers. Many movers will have pre-existing endowment plans but even if they have, their lenders do not appear to be in the know.