6 reasons to avoid an interest only mortgage

Interest only mortgages have become increasingly popular, as house prices have risen out of the reach of many would-be buyers. But anyone thinking of going down this route as a cheap way of getting on the housing ladder needs to tread very carefully. Although mortgage regulations stipulate that lenders should take into account your ability to repay, the paternalist days are long gone. Now, as long as lenders are satisfied that you can afford the interest repayments, banks and building societies are generally happy to hand over the cash, taking your word for it that you will be able to repay the capital - and, if the worst comes to the worst, they will simply repossess the house.

Research last year by Abbey found that about one in five housebuyers who took out interest only mortgages said they had done so because they would not have been able to afford a house otherwise. This is backed up by data from the Council of Mortgage Lenders, which shows that, while nearly three-quarters (74%) of first time buyers last year took out a repayment mortgage, more than a fifth (21%) took out an interest only loan -up from an eighth two years earlier. Worse, more than 16,000 of these borrowers - or 15% of the total - have no repayment vehicle, an increase from 10% in 2003.

And it's not just first-time buyers who are playing with fire. Increasingly, people cashing in endowment policies are failing to make arrangements to repay the capital. Interest only mortgages can work well in some cases - for instance, some people can make capital repayments on an irregular basis out of bonuses from their jobs.

But here are six reasons why interest only loans should be avoided by all but the most sophisticated borrower:

• You won't have an equity safety net - If anything happens to you, such as ill health or redundancy, and you can't meet your repayments, you won't have built up any equity in your home to give you a buffer for rescheduling the loan with your lender.
• Alternative saving plans are risky - In the present low-interest environment, using a means of repayment outside a mortgage scheme leaves you with an above-average chance of failing to hit the target for repaying your loan when the time comes. Returns on savings accounts with banks and building societies are usually too low, and you have to pay tax on many of them. You therefore need to take some degree of risk with your alternative savings scheme, such as investing in stocks and shares, which means that if the market turns against you, you could be left with a shortfall. This has been the problem with endowment schemes.
• Don't put off till tomorrow what you can pay today - Putting off repaying capital for a couple of years, and changing to a repayment mortgage later on, might be a sensible option if you could be sure you would have a higher income in a few years' time. The difficulty here is that your circumstances might change. Dual income couples find themselves with just one earner in the family and another mouth to feed if a baby comes along.
• A lottery win will probably never happen - If you are relying on an inheritance or a business deal to pay off the loan, you need to be sure that the money will materialise. For example, what if the tax laws changed and you did not get as much cash as you thought you would, or Uncle Albert changed his will at the last minute? If you were thinking of relying on a lottery win, don't!
• You will pay more interest - If you don't start paying down the capital from the start you will pay more interest in the long run.
• You might not be able to sell when you want to - Selling the property to pay off the loan is the strategy used by many buy to let investors, but it is not really suitable if you need to live in the house.

Some people reckon they will "downsize" when the time comes to pay off the capital, but people's circumstances change and you may find you don't want to move, or there is nothing suitable for the money you have left once you have repaid your loan.

Relying on paying back the loan with the proceeds of a sale is a very dangerous gamble, since your property might not increase in value as much as you hoped. Even if prices do rise, if you borrow £100,000 you will still owe £100,000 at the end of the mortgage term. And, by the time you have paid moving costs, you may find the house you planned to downsize to is still out of financial reach.

In any case, however you propose to repay your mortgage, remember to review your plans from time to time, to make sure that they are still on track to repay the loan when the time comes - or you could lose your home!

08 March 2006 © Moneyextra.com

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