Interest-only mortgages were once the bread and butter of the UK mortgage market.
However, a legacy of underperforming endowments and the 2008 financial crisis cast doubts that this method of home financing was viable.
But with rising rates and tighter finances, there's a renewed discussion about their potential comeback. Is it their time to shine again?
The concept of an interest-only mortgage is straightforward enough. Monthly payments only address the interest on the loan throughout the mortgage term, which can last from a few years to more than three decades. This leads to reduced monthly payments.
For instance, a £200,000 mortgage at 5 per cent interest over 25 years would mean monthly payments of about £833 with an interest-only plan, a notable decrease from the £1,169 on a standard repayment mortgage.
This reduction can be a financial relief, especially in regions with skyrocketing property prices.
Moreover, interest-only mortgages offer inherent flexibility. They can benefit homeowners with variable incomes, such as freelancers or those heavily reliant on bonuses.
The debate around interest-only mortgages isn't just about finances.However, unlike repayment mortgages, where both interest and principal are paid, with interest-only, the principal remains untouched until the term ends. This means at the end of the term, borrowers still owe the same initial amount they borrowed.
To obtain such a mortgage today, lenders typically demand solid evidence of a repayment vehicle, such as an investment or Isa, to ensure the borrower can repay the full sum.
This can potentially earn returns that surpass the mortgage interest.
However, it's not all positive. The primary drawback is the lack of equity accumulation as homeowners might find themselves with an unpaid mortgage principal upon retirement.
The 2008 financial crisis highlighted the risks of interest-only agreements without a clear exit plan. Negative equity became a significant issue, and some found themselves trapped in their mortgages, unable to refinance.
This situation becomes even riskier when no principal has been paid.
Making a comeback?
Regulatory changes in 2014 further pushed interest-only mortgages to the fringes. Yet, as economic challenges persist and spending power wanes, there's a case for cautiously reintroducing interest-only to the mainstream market and easing the criteria for flexible mortgages.
Flexible mortgages, though rare, offer various features, including overpayments, underpayments, and payment holidays.
Overpayments help by reducing the principal, saving on interest, and shortening the term. Conversely, underpayments suit those with fluctuating incomes.
Payment holidays, which became popular post-pandemic, offer temporary relief for those difficult months.
However, just like interest-only mortgages, if the borrower isn't careful, they can end up with no way of paying the remaining amount at the end of the loan.
The debate around interest-only mortgages isn't just about finances.
The last few decades have seen unprecedented changes in the UK housing market. Property values in some areas have turned homeownership into a lofty dream rather than an attainable goal.
In this context, the attraction of an interest-only mortgage becomes even greater. For first-time buyers and younger generations facing stagnant wage growth and massively increased living costs, the prospect of lower mortgage payments is certainly enticing.
It offers a foot on the first rung of a housing ladder they might not otherwise be able to ascend.
Navigating this area requires a balance between offering payment flexibility and safeguarding borrowers.
While there's no universal solution, the lending market must start providing a broader range of options and catering for the underserved, or we risk no longer being a nation of homeowners.
Peter Stamford is lead adviser at Moor Mortgages
