There has been much publicised of late in respect of interest only borrowing and potential short falls to repay the mortgage at the end of the mortgage term.
Interest only mortgages allow the home owner to simply pay the interest each month but none of the capital. As such, the outstanding balance on this type of mortgage will remain the same for the entire term of the mortgage.
At the end of the mortgage term, the mortgage lender will then request that the home owner repays the capital in one lump sum.
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Due to the current economic conditions some people have switched to interest only borrowing in an attempt to reduce their monthly mortgage payments and rescue their finances. Although switching to interest only will certainly reduce payments, this is not what this type of mortgage was intended to be used for.
Others simply have investment plans which are not on track to provide sufficient funds to repay the borrowing and may face financial hardship if action is not taken to resolve such issues.
In order to repay the outstanding capital at the end of this mortgage type, home owners are most likely to pay into an investment throughout the course of the mortgage in the hope that this investment will yield the necessary return which they then use to repay the mortgage lender.
Research has shown this is in fact not the case for many homeowners and the average shortfall for repaying the capital is £70,000.
For people who fear that they may find themselves in this situation there are ways to address the issue. There is the option of converting your mortgage to a repayment mortgage. The benefit of this is that you will be guaranteed to have repaid the debt by the end of your term. However your monthly payments will increase as a result and so the question of affordability must be addressed before proceeding with this course of action.
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Alternatively, it might be possible for you to convert a portion of your mortgage to a repayment basis. This should ensure that any remaining mortgage capital will be reduced by the end of the term.
This will again increase your monthly payments but is an alternative option for those who do not wish to convert their entire mortgage onto a repayment basis.
Finally some mortgage providers will allow you to pay off some of your mortgage capital each month or make lump sum payments to reduce the debt. Whichever option you choose, it is important to identify any shortfall early and to take action before it is too late.
Worryingly some owners who have an interest only mortgage do not even have a relevant investment in place to enable them to pay of the capital balance outstanding.
Sadly, this will result in many of these people being forced to sell their home or even losing their home entirely.
The most frequent reason given by home owners who have are switching to an interest only mortgage without an investment vehicle in place is that the change is temporary and at some stage the home owner intends to switch back to a capital and interest.
Unfortunately, many people who switch to an interest only borrowing find they cannot afford to switch back to capital and interest later in the mortgage term. Equally, these home owners find they can rarely afford to pay into a relevant investment. This leaves people paying an interest only mortgage they have no means of repaying later on.
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Some people who are on interest only mortgages intend to sell their home in order to repay the capital outstanding. Sadly, in some cases selling a property can be a lengthy process and now more so than ever, people are finding they are unable to sell for the figure they anticipated. Again this could leave a shortfall on an outstanding mortgage balance.
That said, interest only mortgages are relatively common and are being used by some to great effect. However for those who fail to understand the true purpose of this type of mortgage, interest only could be a ticking time bomb.
* Trevor Law is a director with Merito Financial Services, chartered financial planners, based in Solihull.
E-mail: tilaw@meritofs.com