With the recent furore 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 Basics of Interest Only
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, 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 which with regular payments and investment growth. This provides a mortgage which establishes a long term repayment strategy. If choosing a conventional interest only mortgage.
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 day. This is where the 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 can 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 being 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 and 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 and 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.
Alternatives for Retirees
The above is a discussion of conventional interest only mortgages. There is another type of interest only mortgage under the lifetime equity release scheme. The lifetime mortgage is for retirees. As a retiree it is possible to take out money and repay it in the distant future. For instance, if you need money, but you are retired you have pensions and retirement savings. You usually do not have income. The principle balance remains unpaid until your death or move to a new place. You still pay interest each month based on an APR.
• The benefit is you have more money to spend during retirement, while you maintain minimal payments.
• You also leave an inheritance behind because you pay off the interest leaving some equity in the home that is gained at the future sale to repay the interest.
• A downside is that not all retires can afford to repay interest throughout their retirement.
Certainly interest-only mortgages for retired and non retired individuals take consideration of all information, but at least there are products to help you.