According to the Abbey, more than a quarter of homeowners are paying for their homes with an interest-only mortgage. The reason is clear – their monthly payments are much less. For example, a £150,000 interest only mortgage at an interest rate of 5% and repayable in 25 years time, costs £625 per month - but on a repayment basis the same financing costs £875 per month.

These cash flow savings have understandably proved highly popular with first time buyers getting their feet on the property ladder and others working on a tight budget. The problem is that some 37% of homeowners with interest only mortgages are not saving any money towards repaying the capital when the mortgage eventually comes to the end of its term.

The Financial Services Authority (FSA) has not ignored this problem. Last year they ushered in new rules requiring lenders to seek evidence from new borrowers about how they intend to repay the capital in the future. If the borrower says they’ll repay by selling the property, that simply won’t be sufficient. The FSA is likely to judge as miss-sold, any new mortgage that is granted without details of a verified repayment vehicle to generate a sum large enough to repay the mortgage. And, if the figures don’t stack up, the lender will get into deep water with the FSA.

The sort of repayment vehicle they will be looking for will be an Individual Savings Account (ISA) or an existing personal equity plan (PEP). Even the 25% tax-free cash from a personal pension plan (PPP) will do. But you’ll have to provide documentary evidence to the lender that these financial arrangements are in place – just saying you will do it sometime in the future won’t wash.

From reactions so far, it’s quite clear that individual lenders will interpret the FSA’s rules in different ways. Take the Nationwide Building Society for example: their new rules say that you can’t qualify for an interest only mortgage if you plan to repay using future pay rises or an inheritance. Even if you claim you’ll fund an ISA from bonuses rather than from regular income, you’ll be required to prove that such a bonus scheme exists and that the level of bonus relied upon is realistic. However, the Nationwide are prepared to provide an interest only mortgage if you are not a first time buyer, have at least £150,000 of net equity in your existing property and the mortgage you want is less than two thirds of the new property’s value.

Many mortgage advisers believe that interest only mortgages should only be used as a last resort when income is tight. That’s because whichever investment vehicle the borrower decides on, the investment returns are never guaranteed and the investment might not deliver sufficient capital at the end of the term to fully repay the mortgage. This means there’s always an element of risk involved. For this reason, many advisers prefer to be sure and recommend a repayment mortgage where there is absolutely no risk of a shortfall.

Having said that, some mortgage advisers acknowledge that an interest only mortgage can be useful if the borrower plans to simply use the mortgage’s lower repayments as a temporary stop gap of say five years, and then switch to a normal repayment mortgage. Of course, the FSA’s rules will still expect the borrower to show evidence that a suitable saving or investment plan is in place prior to releasing the funds for an interest only mortgage.

However, if advisers do recommend an interest only mortgage, most rightly recommend a scheme where the borrower can make penalty free overpayments. With these schemes, the borrower isn’t committed to making a higher monthly repayment, but as and when spare capital becomes available, lump sums can reduce the outstanding mortgage. There are lots of mortgage packages available like this and most allow the borrower to repay at least 10% of capital penalty free each year but check out the details before you sign up for the mortgage.

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