Home hopes of the young and self-employed will be dashed if interest-only mortgages go

The clock may be ticking for interest-only mortgages.

The once highly popular product, which accounted for a third of all new home loans in 2007, is at risk of being killed off. The Financial Services Authority (FSA), as part of its credit crunch clear-up, has said it would like to see firms tighten dramatically their criteria for making the type of loan which allows borrowers to only pay the interest rather than make capital repayments.

Now the trade body, the Intermediary Mortgage Lenders Association (IMLA), is warning that hundreds of thousands of would-be house buyers from self-employed through to young first-time buyers could frozen forever out of the property market.

Peter Williams, IMLA's executive chairman, said: "If the FSA brings in tight controls, it could alter how easily people can enter the market. For example, a young graduate who may be on an incremental pay scale could miss out even though a lender might have offered them an interest-only loan, knowing that they will over time be able to make capital repayments."

Additionally, lenders would have to make annual checks to ensure that borrowers have suitable repayment plans in place. IMLA has said that this will only serve to put lenders off.

"On the face of it these checks sound sensible, but if, as a lender, I confirm your case, you could effectively be relying on my guarantee. Rather than simply checking, the lender is seen to have sanctioned the investment strategy that underlies the loan," said Mr Williams.

Although unsuitable for many borrowers, an interest-only mortgage's attraction is that the initial monthly payments are much lower because only the interest is cleared, not the capital as with a repayment mortgage. When paying off a £150,000 loan over 25 years, an interest rate of 4 per cent would cost £792 per month for capital repayment borrowers but only £500 per month on an interest-only deal.

Brian Murphy, head of lending from the Mortgage Advice Bureau, said: "Unfortunately, as circumstances change personally and in the market, these best-laid plans, although made in good faith, sometimes come apart."

Relying on house price rises to cover the debt is a particularly risky strategy as many first-time buyers who bought at the height of the boom are finding too their cost.

Melanie Bien, from mortgage broker Private Finance, said: "The FSA wants to protect vulnerable borrowers and is concerned that first-time buyers are opting for interest-only mortgages with no thought as to how to pay back the capital because the payments are cheaper than a repayment mortgage."

Lenders, however, are already moving away from the market to a certain extent. In July of this year interest-only mortgages accounted for only 17 per cent of house purchases, a far cry from the figures during boom time. "The market is already stifled and there is less consumer choice. A blanket ban on interest-only does the housing and mortgage markets no favours at all," said Ms Bien.

If, as IMLA suggests, the clampdown by the FSA does see the end of these loans, many responsible borrowers stand to suffer loss.

An example would be high earners who may be on relatively modest income but receive big bonuses and use lump sums to clear large chunks of their mortgages when they are able to do so. Another would be self-employed homeowners who need a mortgage that fits their fluctuating income.

Having no interest-only mortgages will also mean that many landlords suffer who would normally be safe from the typical risks associated with these loans. That is because the property isn't actually their home and they can offset mortgage payments against income when settling their tax affairs.

The real challenge for the FSA, therefore, is to retain interest-only products as an option for suitable borrowers while still protecting their ability to maintain their mortgage in an erratic market.

"While it is easy to understand why the FSA wants to take a watching brief on interest-only mortgages, for the regulator to have a one-size-fits-all approach is not helping either borrowers or lenders and over-regulation could potentially have a detrimental impact on the wider housing market," said Mr Murphy.

Expert View

Melanie Bien, Private Finance

"Interest-only mortgages suit some borrowers and if they disappeared completely it would significantly reduce consumer choice. One size doesn't fit all when it comes to mortgages, and interest-only is the right option for a certain type of borrower who understands the risks and has thought about how they are going to repay the capital at the end of the mortgage term."