Rate rises to hit interest-only mortgages

The Bank of England may have left interest rates on hold this month, but how long can the cost of borrowing be kept so low?

With inflation well above target, the smart money is on a small interest rate rise over the the next couple of months with further rises likely later this year and early next. A rise in rates will bring blessed relief to hard-pressed savers, while most mortgage holders should be able to cope – provided the rises aren't too large or sudden. But there undoubtedly will be borrowers who find even a relatively small rise in rates too much for their finances to bear.

Out of this group the most vulnerable – according to debt charities and mortgage industry insiders – are the millions of homeowners who decided to go for an interest-only mortgages.

"Those on interest-only mortgages are more likely to be on lower incomes, reflecting the relatively smaller monthly mortgage payments required, and therefore are less able to withstand these budget pressures," said Una Farrell from the Consumer Credit Counselling Service, a debt charity.

Interest-only mortgages were traditionally targeted at buy-to-let investors as they could offset some of the interest against tax on rental income. However, during the final years of the housing market boom, interest-only mortgages were taken out by many first-time buyers. In 2006, a staggering 31 per cent of new mortgages were interest-only. This means that potentially millions of borrowers are in deals which require them to pay only the interest on the mortgage rather than the capital. And with rates set to rise and the housing market and economy in the doldrums, there could be hard times ahead for interest-only borrowers.

"Interest-only borrowers who are in essence gambling on future house price rises to pay off their mortgages could be in for a big shock, particularly those living outside London and the South-east," said Ms Farrell. "Not only could they not be able to repay their mortgages, their debt could be bigger than their home's value."

Figures from financial information site Defaqto highlight the potential fallout from even a small rise in rates. On a £100,000 mortgage an increase of 1 percentage point would boost monthly payments by £83. On a £200,000 mortgage, payments would go up by £166. A rise in rates of 2 percentage points – which would still be well below the historic norm – would mean payments on a £100,000 rising by £166 and on £200,000 home loan by a whopping £333 a month.

"If you have an interest-only mortgage, it is important that you adequately fund a suitable repayment vehicle, such as an individual savings account. You should also review it regularly – and adjust the amount that you are saving if necessary – to ensure that it remains on track to pay off the mortgage at the end of the mortgage term," said David Black, Defaqto's banking analyst. "No one knows when and how quickly the bank base rate will increase and many borrowers with variable rate mortgages, and indeed those with an impending maturing fixed-rate mortgages, could be in for a nasty financial shock when their monthly mortgage payment is increased."

Some borrowers reading the interest rate runes have been making higher than required repayments on their mortgages. The Bank of England said last week that it was seeing substantial repayment of mortgage debt, but after a splurge lasting well over a decade borrowers have a long way to go.

"With house prices static or falling and the loan-to-value ratio so important in determining available mortgage deals, boosting the level of equity will improve new mortgage deals available as well as reducing the overall interest bill," said David Hollingworth from broker London & Country. The higher the mortgage as a percentage of the property value, the more expensive and harder to obtain the mortgage." And without equity, Mr Hollingworth said, borrowers will find it difficult to switch to another lender when their deal comes to an end, meaning they will be shunted on to more expensive variable rate deals which in turn are more reactive to Bank of England rate moves.

Interest-only mortgages are much harder to obtain than they were during the market boom. And of late, several major providers have tightened lending criteria even further. "Borrowers will need to provide evidence of an acceptable repayment vehicle and lenders will limit the loan to value to 75 per cent of the property value," said Mr Hollingworth. "Nationwide is just the latest to take this approach, following a similar move by Halifax which also takes effect this week. This should all make interest-only borrowers think now about what they are doing to cope with a higher interest rate world."

Expert View

David Hollingworth, London and Country Mortgages

"If you're an interest-only borrower and haven't already put a repayment plan into place, do so now. What's more, try to follow the example of those borrowers who have been overpaying so as to bring down their outstanding mortgage debt."