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3 Aug 2019

Could you afford a retirement interest-only mortgage?

New research suggests living comfortably while paying for one could be difficult

Most interest-only mortgage customers can't afford to switch to retirement interest-only (RIO) deals due to lack of pension savings, Royal London research suggests.

In the next five years, hundreds of thousands of interest-only mortgage customers will reach the end of their terms with no way to pay off their loans.

RIO mortgages are meant to be a lifeline for homeowners approaching retirement. But new research says most people with interest-only mortgages will lack the funds to afford a RIO if they want to keep up their living standards.

Here, we look at whether RIOs really are unaffordable, or whether they could still be a smart way to settle mortgage debt.

Who are RIOs for?

Retirees, or those approaching retirement, often struggle to get repayment mortgages because their pension income is too low to pass affordability checks.

Which? analysis from April also found that one third of mortgages need you to be 75 or under by the time your term ends. Again, this cuts out many older borrowers.

RIOs were introduced specifically to help people who are trapped by these conditions.

As with regular (i.e. non-retirement) interest-only mortgages, borrowers with RIOs only need to make monthly interest payments rather than payments that cover the interest and some of the loan balance, as is the case with repayment mortgages.

What makes a RIO different is the way you eventually pay it back.

Other interest-only mortgages need you to have a repayment strategy of some kind in place for the end of the term. This could be savings, investments or assets, for example. Or it could be selling your home and downsizing.

With a RIO, your repayment vehicle will be the sale of your home when you die or move into long-term care.

In theory, RIOs are ideal for older borrowers who have no way of paying off their soon-to-expire interest-only mortgages. Instead of scrambling for funds last-minute, you could remortgage and switch to a RIO, giving you the peace of mind that you won't have to pay it off in your lifetime.

But new research suggests it's not that simple.

Are RIOs unaffordable?

According to mutual insurer Royal London, someone with an average income would need a pension pot of around £260,000 when they retire to maintain their standard of living. That could fund a monthly income of £767 a month, after buying an annuity. But this assumes they have paid off their mortgage.

The average balance of an interest-only mortgage when it ends is £121,000, according to regulators the FCA.

Royal London says the typical RIO mortgage interest rate is 3.99%. This would mean monthly interest payments of around £400 on a £121,000 mortgage.

That's a significant chunk of your £767 monthly income. The research states you'd need £118,256 more in your pension pot to buy an annuity that covers the mortgage.

Many retirees might find RIOs much easier to afford, though.

Royal London's calculations don't take into account the full state pension, which pays out £712 per month. And it doesn't account for people on final salary pensions.

In 2018, there were seven million active members of defined benefit pension schemes, according to the Office for National Statistics. This means they have a guaranteed income paid to them in retirement, rather than a pot of cash to convert into an income, and they tend to rise each year with inflation.

Then there's the difference your mortgage balance can make. It could be lower than the £121,000 average, and you might get a better deal than 3.99%.

The truth is, lenders are obliged to carry out thorough affordability checks before they grant RIO mortgages. Many of the lenders that offer RIOs undertake 'manual underwriting', meaning they assign staff to carefully review your application, rather than automated systems, so you'll only get one if you'll be able to afford it.

It's worth seeking advice from an impartial mortgage broker if you're wondering if a RIO is for you.

How else can older borrowers pay off interest-only mortgages?

If you can't afford a RIO, or if you just want to take a different approach, there are alternatives that could help you pay off your interest-only mortgage.

Making overpayments

If you have the money, and if you still have time to do it, overpaying your interest-only mortgage will leave you with a lighter burden when it comes to term.

By paying more than the interest payments, you can reduce your loan balance month-by-month, leaving you with a smaller total in the end.

Lifetime mortgages and equity release

If you have equity in your property, equity release could help you. With a lifetime mortgage, you can 'withdraw' money from your equity and take out another loan to cover it.

You pay off a lifetime mortgage through the sale of your home when you die or move into care, just as you do with a RIO. The key difference is that lifetime mortgages don't require any monthly payments.

There is a downside to this: you'll still build up interest on your loan balance. And because you're not paying it off, the final amount you owe will likely be much higher than the loan you took out.