Conal Gregory: A constructive way to solve the interest-only dilemma

Many are taking out interest-only loans without any proper arrangement in place as to how to repay the capital. In the last three years, households have switched £60bn of mortgage debt from a repayment basis to interest-only.

With the average mortgage standing at £109,000, such a switch saves £230 a month. Yet it is a dangerous financial move if no thought has been given as to how to repay the loan.

For those with healthy savings – possibly in a tax-efficient vehicle like an ISA – or expecting to use the proceeds of an endowment policy or a quarter of their pension, an interest-only home loan makes sense.

The danger for others, and even those with savings in place, is for interest rates to take off. Around 12 per cent of mortgages are today written on an interest-only basis with 85 per cent on a full repayment basis and the balance a mix of both.

Interest-only has been falling in popularity, from 77 per cent 20 years ago (when it was linked to endowment policies), to 27 per cent a decade ago.

The regulatory watchdog, the Financial Services Authority, has been examining the background to interest-only mortgages. The report it commissioned from IFF Research in December 2006 found that one in five would have real difficulties in meeting their financial obligations if interest rates rose by just one per cent. Yet many had taken out such loans on the advice of a professional intermediary who presumably had carried out a risk assessment.

The Council of Mortgage Lenders says that “on the whole, people understand the benefits of repaying debt, building up an equity cushion by repaying the capital and reducing the amount of interest paid over the life of the mortgage”.

Yet we are entering very troubled waters. Mervyn King, Governor of the Bank of England, says to expect the most dramatic squeeze on family finances since the 1920s.

The Government has had no alternative but to take tough measures. If Brown’s public expenditure plans had continued, which are still advanced by the Shadow Chancellor, the nation’s debt would double to £1.4 trillion by the end of this Parliament, resulting in 20p in every pound taken in tax spent on debt interest alone.

The FSA is considering setting limits on mortgage products, notably the maximum loan-to-value (LTV) ratio and sums borrowed relative to income. The Institute for Public Policy Research argues for deposits to be at least 10 per cent and for loans to not exceed 3.5 times a borrower’s salary.

Noted mortgage brokers John Charcol reveal that 90 per cent LTV can still be obtained from smaller lenders like the Darlington and Vernon, provided the borrower has a suitable repayment vehicle in place. The UK’s largest building society, Nationwide, restricts interest-only mortgages to 75 per cent LTV.

House prices are almost flat. The Land Registry reported a 0.8 per cent rise in April with just 0.2 per cent for Yorkshire and Humberside.

Even though many mortgage rates are lower than inflation, which is 5.3 per cent excluding home loans, two-thirds of non-homeowners believe they have no prospect of buying a home.

Yet new housebuilding is one of the key signs to kick-starting the economy. Builders are trying to help with shared-equity schemes. Such plans have assisted 30,000 first-time buyers to get on the ladder in the last three years with loans set at 10-50 per cent of a property’s value, which is repaid after a fixed period.

Housebuilders have subsidised home purchases by more than £800m since 2008, lending on soft terms. Others rely on parental finance. The answer is not to environmentally destroy fresh land but, in part, to have more imaginative urban renewal schemes.

While house prices this year may fall 1.4 per cent, the Centre for Economics and Business Research predicts a 16 per cent rise by the end of 2015.

It puts such growth down to looser lending criteria once bank balance sheets return to better levels and a shortage of property.

The interest-only dilemma is overcome by locking into a low fixed rate, but simultaneously repaying the capital, using a fund or other savings vehicle which will create more growth and income than the mortgage company wants in interest.

It’s a tough challenge but it can be achieved.

Read Conal Gregory in the Yorkshire Post every Saturday.

Conal Gregory is the Yorkshire Post’s personal finance editor.