Stuck with unpalatable options

With the housing market in the doldrums and interest-only borrowers unable to refinance or switch to a repayment deal, lenders are finding themselves between a rock and a hard place

In 2009 an article on interest-only mortgages began by saying that “interest-only mortgages offer a cheaper way to purchase a property than with a capital repayment mortgage”.

One would have thought that by 2009, the public would have had a better understanding of the risks of the interest-only mortgage model. Too often, interest-only mortgages help a borrower buy into housing they can’t really afford at the time.

The assumptions underpinning these mortgages – certainly those granted with no repayment vehicle – means over 70% of interest-only mortgages depend on a buoyant housing market. Borrower and lender are relying on increasing house prices to allow successful refinancing or sale of the property.

Of course, as long as the borrower continues to have enough earning power and the foresight to save, things can still turn out all right if the housing market is not as strong.

But in 2012, when the economy and housing market are both weak, and despite the lowest interest rates in a lifetime, many borrowers cannot refinance or afford to switch to a repayment mortgage.

Lenders are stuck with unpalatable options for interest-only mortgages coming to an end which cannot be repaid or refinanced – extension or repossession.
For most borrowers, interest-only should not be an option, particularly when linked to high leverage. The size of the purchase and leverage allowed, even at conservative 75% LTVs, means that for most people it is the single largest asset and liability they will ever have.

If all goes according to plan, leverage works its magic and the owner comes out well ahead. But when it goes wrong, the cost is huge and can destroy a family. That is not to say the same can’t happen with repayment mortgages, but as every month goes by, the borrower on these mortgages is working at reducing their risk.

So where does that leave existing interest-only borrowers? Depending on how much equity the borrower has in their property, the answer is either to do nothing, where there is substantial equity – to be safe, somewhere around 30% – or to put in place a savings plan that can build up to an equivalent of 30% of value over the time remaining on the mortgage.

Value should be viewed as market value today, not the price that all home owners hope a property is worth. For borrowers who do not fit into either category, a discussion with their lender, in particular if their mortgage is maturing in the near future, is a way to start.

Maybe the first sentence of that 2009 article should have read – “An interest-only mortgage offers a riskier way to purchase a property than does a capital repayment mortgage.” As the saying goes, caveat emptor.