The proportion of home buyers taking an interest only mortgage is steadily increasing. The reason is clear. Interest only mortgages reduce the monthly repayment as borrowers only pay off the interest and are not making any reduction in the capital they have borrowed.

In the first three months of 2002, 9% of all new mortgages were interest only but by the last three months of last year, this had risen to 23%. And amongst first time buyers the rise was from 6% to 15%. (Source: Council of Mortgage Lenders.)

It’s a reflection of people trying to minimise their fixed costs in order to preserve their lifestyle – they still want their nice cars, nights out and holidays abroad. But borrowers’ reluctance to cut back a bit on their life style spending, combined with steadily rising house prices, could be storing up problems for them in the future. If they’re not chipping away at the capital now, how exactly are they going to repay it?

Many lenders are now becoming much stricter by insisting that there is a viable repayment vehicle in place before agreeing an interest only mortgage. These repayment vehicles could be the forecast tax-free cash from a pension, or an ISA or some other regular savings or investment scheme. The danger is that having got the mortgage, they subsequently cancel their savings scheme.

If that happens, when retirement arrives accompanied by the impending repayment of their mortgage capital, they’ll be faced with having to sell their house and down size in order to free up sufficient money to repay the mortgage. And that’s a scenario that lenders are anxious to avoid.

Twenty years ago interest only mortgages were the norm with endowment policies being used to underwrite the capital repayment. But as we all now know, returns on endowment policies are not high as many assumed they would be and they’re certainly not the “guaranteed “ repayment solution that twenty years ago many had assumed.

Then during the late 90’s when the shortcomings of endowment policies slowly became understood, repayment mortgages became the norm. Now with interest only mortgages, the pendulum is swinging again. It’s as a result of high house prices and people straining to get onto and up, the housing ladder without being prepared to economise in other areas of their spending.

We are sure that the economics of family finances will continue to fuel the current popularity of interest only mortgages. It will become the duty of the lenders and the mortgage brokers to point out to their clients the alternatives open to them.

In the past, the norm has always been to start the home ownership with a 25 year mortgage. But an alternative could be to stretch it out to 30 or even 35 years. Then at least repayments are being made and when family finances permit, borrowers can make optional lump sum repayments to reduce the repayment term. In any case people tend to move home every eight to ten years and at each move a new mortgage has to be arranged. Those occasions then represent an obvious opportunity to reassess long term family finances.

For example, the monthly repayments for a £120,000 repayment mortgage over 25 years at say, 4.9% would cost £702.42 per month but if the repayment period was stretched to 35 years, the monthly repayment drops down to £603.03.

But there are other solutions. You could arrange a mortgage where part of the loan is on an interest only basis and the balance is on a repayment basis. It’s a sort of mid way option. At least these mortgages start the repayment process and later when you move or the family income builds, take the opportunity to reassess the type of mortgage you need.

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