With the recent furor from the FCA (Financial Conduct Authority) regarding the sale and uptake of interest only mortgages, we take a look at how these controversial interest-only mortgages work. The interest only mortgage is not for everyone, so the information you learn about this particular product is imperative to your decision making process.
Firstly, interest only mortgages operate by requiring a monthly payment to be made to the mortgage lender. This payment made pays off the interest that the lender is charging on a monthly basis.
This differs from a conventional repayment mortgage which pays off both capital and interest, and which results in the mortgage balance reducing over the term. Therefore, this capital and repayment mortgage will guarantee the eventual repayment of the mortgage at a pre-determined date in the future.
An interest only mortgage has no capital repayment element and as such the balance on the mortgage will remain the same for the duration of the term. Therefore, to ensure eventual repayment a separate savings plan can be set up where regular payments are made and investment growth occurs. This provides a mortgage which establishes a long term repayment strategy.
The normal investment plans that are required to pay off an interest only mortgage are usually one of three vehicles. This could be equity ISA (Individual Savings Plan), less commonly a pension plan or a low cost endowment. These products are taken out separately and are the responsibility of the mortgagor to ensure they are on track to pay off the capital amount at the end of the term.
This is where problems have arisen over the years, particularly with endowment policies that have failed to meet expectations.
So, is the risk worth it?
Judging by the majority of plans now maturing and people scrambling for alternative means of making up shortfalls, the answer is probably no.
Endowment policy holders with the fortune of hindsight may have already changed to a repayment mortgage upon receipt of the endowment projections with the red warnings. At least time was on their side and action could then be taken to address any potential shortfall.
But, this wasn’t the only reason the FCA has clamped down on interest only mortgages. These mortgages were becoming increasingly popular with first time buyers who were struggling initially to afford the monthly mortgage payments. The danger of this is the temptation for first time buyers to either not set up a repayment vehicle or never switching over to a repayment basis when finances ease.
Pros and Cons of Interest only mortgages
• Greater control over the savings element, how it is invested and managed
• Option of which investment vehicle can be used and the ability to maximise tax free growth
Managed correctly the investment growth rate could exceed expectations; therefore, you may be able to pay off the mortgage earlier. Alternatively, on maturity if the policy has over performed then the lump sum paid out at the end of the repayment period could be greater than the mortgage balance. This savings excess then can be put to further use which can normally assist their retirement plans.
• There is no guarantee that there will be sufficient funds on maturity to pay off the interest only mortgage balance at the end of the repayment period. This could be due to under performance or insufficient payments being made during the investment period.
• The mortgage debt remains constant during the term
• Some investments such as endowments cannot be stopped and restarted, and others may incur a penalty or fee if premiums cease.
As you can see there are disadvantages of interest only mortgage products. Given that you usually have a term of 10 to 15 years for the repayment there is a definite need to roll-over the remaining mortgage into a traditional mortgage before the term comes to an end.
There is one interest only product on the market that is slightly different than those offered to first-time homebuyers.
This is the interest only lifetime mortgage. It is for retirement aged individuals 55 and up. It is set up to provide you with cash throughout your retirement, where you have a disposable income, and may not pay the loan off until you die. If you have reached an age of retirement you may want to ask your financial adviser about the differences in this type of loan.
Whether you choose interest only mortgage in your young age or as a retiree you should speak with your family about it.
For further details on Interest Only Mortgages visit EquityReleaseAdvice.com.