When it comes to taking out a mortgage, one of the first decisions you need to make is whether to take the loan on a repayment or interest-only basis. With a more expensive repayment mortgage your monthly payments consist of interest to the lender and part of the capital debt. Over the course of your mortgage term you chip away at the mortgage debt and eventually repay it.

If you take out a homeloan on an interest-only basis you only pay interest to the lender for the full term, at the end of which you owe exactly the amount you borrowed. Prudent borrowers also open an investment vehicle (such as an endowment or ISA) into which they pay additional money each month, in the hope it will grow by enough to repay the debt. There is no guarantee this will work as it could leave a shortfall for the borrower to make up, or it could provide you with a surplus.

In recent years, more borrowers have been taking out interest-only mortgages with no additional repayment vehicle in place – in 2007 20 per cent of mortgages were taken out on this basis according to the Council of Mortgage Lenders. Many were relying on house price increases to enable them to sell the property and pay off the mortgage at the end of the term. The last year has shown that house prices are in no way guaranteed to rise – they’ve fallen by 15 per cent over the last 12 months – and that borrowers should have a plan in place for paying off their debt.

Changing criteria

After years of generous lending on an interest-only basis, lenders are beginning to look more closely at this area of the market – and tighten their lending criteria.

Nationwide for example has long had measures in place to prevent borrowers taking out ‘pure interest-only’ deals – interest-only mortgages with no investment plan alongside them. Katie Moore, spokesperson for the building society, explains: “We do allow borrowers to take out interest-only mortgages, but we also ask that you have a suitable repayment vehicle in place, for example an investment plan such as an equity ISA. Contributions to the plan are invested with the aim of building up a lump sum that could be enough to pay off your mortgage.”

Britannia Building Society also allows customers to take out an interest-only mortgage but according to Jayne Dono, spokesperson for the lender, “the customer must be able to demonstrate that they have a suitable repayment vehicle in place to repay the loan at the end of the mortgage term.”

She adds: “We have reviewed our criteria on a regular basis over the last 18 months in response to the emerging market changes. We anticipate that this will continue and we are currently considering what type of repayment plans we should accept for an interest-only loan.”

Cheltenham & Gloucester has altered its interest-only criteria, adding in a requirement of at least a 25 per cent deposit in October for anyone who wants to take a loan on this basis. This is on top of the existing requirement to have an investment vehicle in place.

Yorkshire Building Society also asks borrowers for proof of an investment vehicle, but is more flexible with those who have a larger deposit or level of equity. Steve Herrick, lending risk assessment manager, explains: “Below 75 per cent loan to value we will accept ‘sale of property’ and ‘general investments’ as methods of paying back the mortgage in addition to traditional investment vehicles.” However, Herrick is keen to stress that Yorkshire’s criteria is currently under review.

Move to safety

Interest-only mortgages are in decline according to recent research from lender Paragon Mortgages. Managing director John Heron says: “We have seen lenders become far more cautious over the past 12 months and less prepared to lend to customers on an interest-only basis.”

Research from the lender showed that the number of interest-only mortgage deals in the mainstream residential market has dropped. It says that interest-only accounted for 23 per cent of mortgages introduced by advisers during the third quarter of 2008. This was down from 26 per cent in the first quarter of the year. Conversely, repayment mortgages have risen this year, after being in decline since 2001, accounting for 60 per cent of mortgages introduced in the third quarter.

The reluctance of lenders to offer pure interest-only mortgages has meant that borrowers are looking to repayment deals. After all, an interest-only deal may be cheaper, but not if you also have to put additional money into an investment vehicle each month on top of your repayment to the lender.

Another factor in the move towards repayment deals is the fear over house price falls which is putting new borrowers firmly off the deals. Britannia’s Dono says that the lender has noticed a move toward repayment loans and Yorkshire’s Herrick agrees: “We have seen a lower number of requests for new borrowing on an interest-only basis, although we have seen an increase in existing borrowers requesting to transfer from a repayment basis to interest-only, due to financial pressures.”

The desire for the safety of repayment deals, combined with the reluctance of lenders to lend on a pure interest-only basis highlights the caution currently being displayed across the mortgage market. And with house prices still falling and fear of job losses rising, it is no bad thing. There may be circumstances in which interest-only mortgages will be suitable but, for the majority of borrowers, knowing that your monthly payments are going towards repaying your initial borrowing offers a degree of safety worth its weight in gold.

Benefits of interest-only

They are cheaper. A £200,000 mortgage at 5% interest will cost you £1,169 a month on a repayment basis and £833 paying just the interest

Because they are cheaper, there is less potential of getting into arrears on your mortgage – which would be costly

Your debt depreciates in value over the long term because of inflation

You can take out an interest-only deal for a couple of years and then move to a repayment mortgage when you move or remortgage – but you will see a rise in repayments when you do so

If you have extra money you can overpay your interest-only mortgage and the overpayment comes straight off the capital debt. So you can repay some of your mortgage (usually 10% a year) with the security of having low minimum payments for the tight months

There can be tax advantages for buy-to-let investors.

Drawbacks of interest-only

Unless you put money into an additional repayment vehicle, or sell the property, you may have no means of repaying your debt at the end of your term

You might put money into an investment vehicle that does not increase by enough to repay the debt, leaving a shortfall that you have to meet (or it might rise by more than the debt and leave you with a tax-free windfall)

There is no guarantee that property prices will have risen by the end of your term. They may fall and then you will have to sell the property and make up the difference to repay the mortgage

If you need to move or change your mortgage for any reason you might find it difficult. While prices usually rise over the long term there are short-term dips. If you get stuck in negative equity you will find it hard to remortgage or move house.