More than 100,000 interest-only mortgages will mature this year – but that still leaves over 1.5 million interest-only home loans outstanding.
Mortgage watchdogs fear many people in this position “do not have an appropriate strategy” to repay loans.
The Financial Conduct Authority (FCA) has said it will investigate how lenders are treating borrowers as their mortgages approach maturity.
Billed as an easy way into the property market, interest-only mortgages were incredibly popular in the Nineties and peaked just before the financial crisis when they accounted for a third of all home loans.
The FCA says there are three peaks when the bulk of these loans will mature.
These are: 2017-18 as a result of endowment mortgages sold in the Nineties and Noughties; 2027-28 from loans taken out between 2003 and 2009; and 2032 partly resulting from conversions to interest-only mortgages during the term.
Here are six suggestions to pay off outstanding interest-only debt. The potential pitfalls are also listed. If one solution doesn’t work for you, move on to the next.
Ways of repaying an interest-only mortgage
- Downsize property
- Extend your mortgage term
- Remortgage to a lower rate and overpay
- Use other savings and investments
- Release equity
- Ask your children for financial assistance
Suggestion 1: Downsize home
The simplest solution is to sell your home and move to a cheaper property. The proceeds from the sale will be used to pay off the outstanding mortgage balance.
Problem: There are several potential snags with this approach. Since the credit crisis the extent to which house prices have recovered has varied enormously between different parts of Britain.
In many areas sluggish prices will have left homeowners who took out loans with small, or even non-existent, deposits in negative equity. That could mean that selling the property does not generate enough to pay off the mortgage.
In any case buying in a cheaper area may not be an option, particularly if this would mean moving away from family and friends.
Securing a new mortgage for a new property may also be challenging. Mortgage companies typically lend up to 75 and will require steady, dependable income which may be hard to prove if you’re retired.
Suggestion 2: Extend your mortgage term
If you’re unlikely to easily pay off your interest-only mortgage by the agreed date, one option is to ask the lender to extend the term.
That gives you longer to save the capital.
Hopefully this would also enable you to switch some or all of the loan to a repayment basis: the reasoning is that by the extending the term your monthly repayments would be lower and this strategy more affordable.
Say you originally took out a 15-year interest-only mortgage for £200,000 in 2007. The capital will need to be repaid in 2022 under that agreement, but you’re worried that you won’t be able to raise the money by then. Say you’re paying an interest-only rate of 3.5pc, giving you monthly interest payments of £583.
If you switched everything over to a repayment basis right now, with just five years left, your monthly repayments (that is interest plus capital repayments) would soar to £3,691.
That would be impossible for most.
So, say you extended your mortgage to run a further 15 years from now until 2032.
In that case your repayments, assuming the same 3.5pc rate, would fall to £1,447 per month. Still high – but you would be guaranteed that by the end of the term the debt would be paid off.
Suggestion 3: Re-mortgage to a lower rate and overpay
Millions of borrowers could save money by re-mortgaging, and this group includes many interest-only borrowers.
The idea here is that if you can cut the mortgage interest costs, you can free up more cash toward paying off the capital part of the debt.
First, check what rate you’re paying. Is it the lenders’ “standard variable rate”? If so, then it’s probably between 4pc and 5pc and – providing you get accepted – you should be able to halve the interest rate or do even better.
For example Santander’s standard variable rate is 4.49pc. Yet Santander offers some rates, such as two-year fixed rates, for as little as 1.19pc.
The cost of monthly interest (not capital repayment) on a £200,000 loan is:
At a rate of 4.5pc: £750 per month
At a rate of 1.19pc: £198 per month
in other words you could cut your interest costs by £552 per month (or £6,624) per year.
Problems: As with the extension of your mortgage term, if you want to switch deal you’re going to have to go through a mortgage application process. This means an existing or new lender will want to assess you based on your income, age and other financial commitments including any other debt and even the number of children you are supporting. Even if you own a large proportion of equity in your property, lenders may turn you away if your income fails the test.
Suggestion 4: Use other savings and investments
If neither of the above mortgage-oriented strategies can work for you, you could instead focus on bringing together other savings and investments as a way of clearing the balance when the mortgage ends.
Many people use the tax-free lump sum from their pension to clear their mortgage, for example (a quarter of the value of your pension can be taken tax-free).
New pension rules applying from 2015 enable money in pensions to be drawn out in large sums, and so this too could help clear mortgage debt. However, beyond the 25pc tax-free element, pension withdrawals are taxed as income – and so care should be taken around large withdrawals made within a single tax year.
Money built up inside Isas or other accounts could also be used to clear the debt when due.
What to do with your endowment policy: Some older borrowers caught up in the interest-only trap are those who were sold endowment policies in the Nineties. They were told that if they contributed to a savings plan for the length of their mortgage (normally 25 years) they would end up with a handsome sum, enough to pay off the capital and to leave a tidy bonus on top. Life insurance was incorporated as part of the deal.
This strategy didn’t work in practice: endowment policies underperformed and their high charges and commissions resulted in massive shortfalls.
Many thousands cashed in their policies or sold them on via a second-hand market.
If you still have an endowment plan in force it is worth looking at the latest “maturity” projection figure.
This will give an indication of what you will get at maturity, which you can factor in to your plans to manage the mortgage end-date.
It is probably not a good idea to encash the plan, especially if you remain in need of the life insurance.
Suggestion 5: Equity release
Equity release sounds complex, but it’s basically just another type of mortgage – one that remains in force until you die or need to go into care.
So for some this will be a way of remaining in the property, without ever actually having to pay off their main, interest-only mortgage.
There are downsides. This is not necessarily the best or cheapest route for everyone.
Equity release describes borrowing against your property, and the most common way to do this is via something called a “lifetime mortgage”.
You don’t usually make monthly payments at all. Instead, the lifetime mortgage means rolling up interest, on top of your original capital borrowed, until you die or need to go into care. At that point the debt is settled.
Example: Say you are 65 today. Your home is worth £300,000 and you have an interest-only mortgage of £30,000 which is due to be paid off in five years’ time in 2022.
You are worried that you won’t have the £30,000 in 2022, and you cannot afford to save much over the next five years because you are already stretched to meet the monthly interest costs of the mortgage.
So you opt to release £30,000 equity when your mortgage becomes due.
Say you borrow this at a fixed rate of 5pc, compounded. You won’t have to make monthly repayments but the debt will roll up, the interest compounded.
Say you die aged 90. In that case your original £30,000 debt at age 70 will have compounded up at a fixed interest rate of 5pc to become a sum totalling £81,379.
How much of your property you can borrow depends on your age.
It also depends on how high a rate you are prepared to pay. The following table gives an indication, based on data available in May 2017:
How much the debt builds up to depends on how long you live, as well as the rate at which your lifetime mortgage is charged. The resulting costs can be high.
It is always worth telling your children or other beneficiaries of your will that you’re entering into this type of agreement ahead of time.
Suggestion 6: Get your children to pay
This is an extension of equity release. In recent years, lenders have become more flexible and have allowed equity release borrowers to pay interest on their loans – if they want to and can afford to. You usually pay a slightly higher rate for this flexibility.
By paying off the interest as you go, you can dramatically reduce the total cost of the debt. In effect, you are simply converting a standard interest-only mortgage into an interest-only mortgage for life.
One potential way of making this work is to get children or other family members to contribute the interest costs of the loan.
This is especially helpful where the children are the beneficiaries of the will: they will ultimately benefit from a higher payout if the cost of the equity release can be kept down thanks to their payments.
What if I do nothing?
Under the conditions of your mortgage, lenders have a legal right to repossess homes where loans have not been repaid by the end of the term.
However, the FCA has told lenders they must treat customers “fairly” as their loans approach maturity.
Part of this is ensuring that staff help borrowers by giving them “sufficient” time to consider their options for a repay plan and knowing enough about customers to assess whether their strategy will work.
Bank or building society staff are likely to suggest some of the solutions mentioned here – be sure to fully understand the implications before agreeing to anything.