Mind This Mortgage Trap!

Borrowers need to beware this trap, argues Christina Jordan.

This article was first sent to Fools as part of our Afternoon email campaign.

The last five years have seen an increase in the number of borrowers taking out a mortgage on an interest-only basis. And they were driven by two main factors.

1. Monthly repayments on an interest-only deal are much cheaper than on a capital and interest `repayment mortgage'. And with house prices moving beyond the reach of many first-time buyers, taking a deal on an interest-only basis was the only way many believed they could afford to get on the ladder. Waiting would only see prices rise further out of their grasp. or so they thought!
2. Interest-only deals didn't seem risky, since property prices were rising so rapidly. You could gain a large equity stake in a property quickly despite the fact that you are not reducing the size of your debt.

All well and good, but of course with an interest-only deal you only pay interest on your debt every month -- and then, at the end of your mortgage term, you have to pay back the entire amount you borrowed.

The prudent borrower

The prudent borrower takes out a repayment vehicle alongside the interest-only mortgage, and sets aside additional money each month that will hopefully grow sufficiently to pay off this debt at the end of the term. This could be an endowment, an ISA, a personal pension plan, or indeed any other type of investment plan you choose.

However, new research from insurance firm LV= has shown that a massive 1.3m interest-only mortgages have no specified investment vehicle in place to pay off the capital. That's nearly half of all interest-only deals (2.9m).

Of these, only 1 in 5 plan to use other investments to repay the capital. A massive 41% (530,000) of interest-only mortgage borrowers are relying on their property's value rising so much that they can cash in their equity to pay off the mortgage -- gulp!

Falls in property prices this year (15% according to Nationwide) and the threat of further falls have shown up flaws in this particular strategy, at least in the short to medium term.

According to LV=, the vast majority (89%) of the £74bn in interest-only loans with no specified capital payment plan, were issued to borrowers in the last five years. Some of those borrowers may find themselves in negative equity -- fine if they do not need to move house or pay off their mortgage in the near future, but a problem if they do. The LV= research suggests that as many as 456,000 interest-only borrowers could be in negative equity by the fourth quarter of 2009, with the worst affected being those who bought in the second half of 2007. A significant 13% believe they are now in negative equity and 41% of those (187,000) are relying on future house price increases to repay their loan.

What should you do?

If you have an interest only mortgage with no repayment vehicle in place and were relying on property price inflation to pay off your debt - don't panic.

The steps you should take depend on what your plans are for the property and your own financial circumstances. If you plan to remain the property for long term and can currently afford your mortgage payments there isn't an immediate concern. But remember that your property's price may not increase over the long term by enough to repay your debt.

And more importantly, life tends to get in the way of the best made plans.

Anything from a new job to a divorce could mean you have to move from your property sooner than expected. And refinancing might be harder than you think in this new environment of cautious lending.

Help yourself

If you can afford it, and a lender will accept you, think about switching to a repayment mortgage. That way you will be able to slowly pay back your debt.

Many borrowers took out an interest-only mortgage with the intention of switching to a repayment deal a few years down the line anyway. So if this was your plan - stick to it, and make the change.

Remember though, this will mean a significant increase in your mortgage payments. A £200,000 mortgage at a rate of 5.5% would cost £916 a month on an interest-only basis and £1,228 a month on a repayment type mortgage. Check out Jane Baker's piece on the pros and cons on both repayment methods.

If you cannot afford such an increase or want to stick with an interest-only plan, see if your lender will allow you to pay overpayments into your mortgage, which will allow you to effectively pay down some of your capital debt.

Most lenders allow you to overpay either up to £500 a month or 10% a year and this is a good way of having the option of paying more when you can afford it, while keeping your actual mortgage payment low for those tight months. Use our overpayments calculator to see how overpayments would affect your mortgage.

Of course, you could set up an additional repayment vehicle alongside your mortgage such as an endowment, ISA or personal pension plan. Each of these options has benefits and drawbacks and it's important you take advice on which will best suit your circumstances.

However 4 in 10 borrowers with no specified repayment plan told LV= that they could not afford to put money aside on top of their interest repayments. A significant 18% said they were intending to use future equity to that they expect to build up in their home to pay off their mortgage. And worryingly 12% hadn't given the matter any thought.

So if you have an interest-only mortgage with no repayment plan in place, at least give the matter of how you will repay your debt some thought, and save yourself hassle further down the line.

More: Why You Don't Need To Remortgage