Borrowers paid interest to their mortgage lender every month and made a separate payment into an investment vehicle called an endowment, which they hoped would generate more than enough capital over 25 years to pay off their mortgage, and leave them with a nice lump sum to spend as they pleased.
This worked for some borrowers for some time, but when the government of the day intervened to remove tax relief on payments into endowments, and stock markets took a dive, thousands found themselves facing a shortfall at the end of their mortgage term. Many borrowers claimed they had been mis-sold – and not given adequate warnings about the risks associated with what had generally been regarded as a one-way bet – and significant compensation was paid to many.
It didn’t help that much of the essential documentation which would have established what borrowers were told and when no longer existed – making it difficult for brokers and lenders to defend claims.
Interest remained
But the demise of the endowment mortgage did not lead to the end of the interest-only mortgage.
Far from it – as the 1980s and 1990s rolled on and house prices continued to rise, increasing numbers of borrowers saw the advantage in being able to borrow more on an interest-only basis – but without the safety of a repayment vehicle which would, eventually, enable them to pay off the capital borrowed.
No doubt some felt it was all too far in the future – and rising house prices would mean they would have sufficient equity, and be able to downsize to a smaller property when push came to shove.
The introduction of mortgage regulation in 2004 required lenders to make it very clear to borrowers who opted for interest-only loans that they would be liable to repay the capital at the end of the mortgage term. The annual statements sent to borrowers were also required to carry that same warning.
But it was not until the Mortgage Market Review (which came into effect in 2014) that the rules on responsible lending were further tightened: from this point, affordability had to be assessed on whether the borrower could repay on an interest-and capital basis, not just interest-only – and interest-only loans were not permitted without clear evidence of a strategy to repay the capital. Further, borrowers were no longer able to ‘self-certify’ their income – which had been a source of numerous ambitious borrowing ventures.
Where we stand today
Why the potted history lesson? Well, despite the regulatory interventions, the Financial Conduct Authority (FCA) estimated that in 2015 there were still two million borrowers in the UK with an interest-only deal (outside of the buy-to-let sector where such arrangements dominate and make sense).
The FCA has remained concerned about the “ticking time bomb” of interest-only loans and has worked at length with lenders to restore the balance. By 2022 the number of interest-only mortgage holders had dropped to less than a million – 750,000 pure interest-only and 245,000 part-and-part.
But in the current market conditions, with higher interest rates and the cost of living squeezing many borrowers till the pips squeak, interest in interest-only arrangements is understandably on the rise. Rare is the first-time buyer who will qualify for an interest-only mortgage, certainly according to mainstream criteria these days, regardless of how much they hanker after those lower monthly repayments.
But switching an existing loan onto an interest-only basis, with the intention of this being a temporary state of affairs, could look like very welcome respite for many hard-pressed existing homeowners, particularly those who have had to refinance just as mortgage rates rose sharply.
So, it is worth reminding ourselves of the basic problem with interest-only mortgages: they may be suitable for some niche groups, such as those looking for a very low loan to value (LTV) loan, coming up for retirement and expecting lump sum pension payouts, for example.
But for most people, at best, interest-only deals are likely to be more expensive in the long-term – and at worst they risk storing up trouble for the future. And when it comes to funding a borrower’s home and hearth, risk has no place in the equation. No borrower should consider going down the interest-only route without first having a careful discussion with their mortgage adviser.
And as every mortgage adviser knows, borrowing on a repayment basis is the only secure way to finance a residential mortgage.
