Hundreds of thousands of homeowners with an interest-only mortgage could face a debt crisis when their loans mature, it is feared.

The Financial Ombudsman Service, the independent complaints arbitrator, expects a flood of complaints from borrowers to come its way unless lenders take steps now to alert borrowers of the dangers of these loans (see the Cheap Mortgage Finding guide).

The chief Ombudsman, Natalie Ceeney, told many of those who took out such a deal during the interest-only "boom" around 10-15 years ago may not realise their mortgage payment will not clear their debt.

An interest-only mortgage is one where your payments only cover the interest, not the loan itself. Therefore, at the end of the term, usually 25 years, you still owe the original loan amount.

Many borrowers on such deals could be gambling with their futures as some took the loan on the assumption they could pay it back by selling their home on maturity. But this relies on house prices holding steady over the length of the deal and leaves them with no asset at the end.

Banks and building societies are toughening their criteria to ensure borrowers prove they are saving cash to pay off the debt before taking an interest-only mortgage (see below).

'Our fear'

Ceeney says: "We know there was a big boom of interest-only mortgages around 15 years ago.

"Our fear is when they mature, people will retire with big debts. We don't want a crisis in 10 years.

"People sometimes get it wrong and misunderstand what an interest-only deal is and think there is a repayment plan in place, but it is something they need to set up themselves."

In the 1980s and early 1990s many interest-only loans were sold alongside an investment, usually an endowment, designed to pay off the loan amount.

However, endowment mortgages fell out of favour in the mid-1990s when it was clear many policies would not cover the full loan amount, though interest-only deals continued to be sold.

How to prevent a crisis

Figures from the Council of Mortgage Lenders (CML) show in 1994, 61% of mortgages sold were on an interest-only basis where the borrower declared they had a separate repayment plan, while 12% were interest-only deals where no plan was in place. Many of the 61% would have been on an endowment basis.

By 1999, 31% were interest-only with a repayment plan, but the percentage sold without a plan shot up to 22% of all mortgages, equating to almost 400,000 new home loans in that year alone.

The key, says the Ombudsman, is to ensure you have a mechanism to pay off the loan itself, as well as the interest. It says lenders can do more to warn borrowers.

Ceeney adds: "Firms need to make it clear an interest-only mortgage won't pay off the mortgage. Our worry is in 10 years we may see a flood of complaints unless lenders warn borrowers now."

Lenders toughening up

While the Ombudsman is worried about those with exiting loans, lenders are toughening the criteria for those taking out new interest-only mortgages.

The biggest changes come from the Lloyds Banking Group, which includes Lloyds TSB, Halifax and Cheltenham & Gloucester.

It is hiking the cost of taking an interest-only deal, making such mortgages 0.2 percentage points more expensive than taking a home loan where you also repay the debt, known as a repayment mortgage.

The lender will also cap interest-only mortgages at 500,000. And it will no longer accept the sale of that property, sale of business or an upcoming inheritance as a borrowers' intended method to repay the debt, when they apply.

Anyone taking out an interest-only plan must also set up a savings or investment vehicle. The Lloyds changes have already started on some deals and should be complete "over the coming weeks".

Other banks and building societies have been gradually tightening up on interest-only lending over recent months. For instance, where some allow you to borrow up to 95% of the value of the property, known as the loan-to-value (LTV), they will only allow a 75% LTV on interest-only deals.

CML figures show in 2009, 14% of homeowners took an interest-only mortgage with no repayment plan specified, compared to 21% in 2008. This proportion is expected to fall further when 2010 figures are released.

David Hollingworth, from broker London & Country, says: "The bottom line is that taking out a mortgage without an established repayment vehicle will become more difficult, but perhaps it should be."

If you're thinking of taking out an interest-only deal, below are the restrictions the largest lenders implement.

Interest-only mortgage restrictions, by lender
Does it cost more? (i)
Max interest-only LTV
Max interest-only borrowing
Repayment vehicle required
Barclays / Woolwich
Same as repayment
Savings/investments or sale of property (only if own 150k equity)
Lloyds TSB / Halifax / C&G (ii)
0.2% more
75% or 85%
Same as repayment
Same as repayment
Same as repayment
Savings/investments/sale of property
RBS / Natwest
Same as repayment
Santander / A&L
Same as repayment
(i) compared to a repayment mortgage, (ii) some restrictions to be phased in over coming weeks

Martin Lewis, creator, says: "Interest-only mortgages aren't bad, they are risky. The investment you use to repay your mortgage may soar or may plummet.

"A gamble on an interest-only mortgage can pay off. But the reason most people should be cautioned against these mortgages is planning, understanding and managing that gamble is complicated."

Further reading/Key Links

Mortgage cost-cutting guides: The Remortgage Guide, Mortgage Haggling, Cheap Mortgage Finding, Ditch My Fix?