CML news & views

Most borrowers take out repayment mortgages, designed to pay back the loan over the term through monthly payments of capital and interest. However, many customers are able and willing to manage their repayment profile to match their personal circumstances, and are currently able to take out a mortgage with the monthly payments limited to interest and the capital repaid at the end of the term, or as and when the borrower can afford it.

Table One: Methods of repayment - all mortgages

Source: CML/BankSearch Regulated Mortgage Survey

Table One shows that in the period up to 2007 there was an increase in the number of borrowers who, because of stretched affordability or for other reasons, took out interest-only mortgages. Since then, the trend has reversed, with more customers taking out repayment loans as lenders and borrowers have become more risk-averse in the current economic environment. This trend has been mirrored by a tightened attitude to product criteria by lenders offering interest-only mortgages. 

Our data shows that, over the last year or so, almost 75% of all loans for house purchase have repayment mortgages. This year, 8% of loans for house purchase have been on an interest-only basis, but with a specified repayment vehicle in place.

So far this year, 14% of mortgages have been interest-only with a repayment vehicle not specified. That does not mean, however, that all these borrowers do not have a repayment plan in place; they may have plans for repaying the capital but have not outlined them to the lender.

Under responsible lending rules already in place, the Financial Services Authority (FSA) requires lenders to take into account the cost of any associated repayment vehicle when assessing a customer’s ability to repay an interest-only mortgage. Where the lender is unable to establish the cost of such a repayment vehicle, it needs to assess costs for the borrower on the basis of a repayment mortgage.

Who takes out an interest-only mortgage?

Interest-only mortgages have been popular for specific groups of customers, including:

• financially capable borrowers who make arrangements to repay the capital through investment over the long term;
• buy-to-let investors who plan to repay the capital through the eventual sale of the property they are renting out;
• older customers with lifetime mortgages who plan to repay the capital by selling the property on death;
• first-time buyers who can afford a repayment mortgage at the outset but who want to keep their initial costs low and instead spend some of their income on setting up their new home;
• first-time buyers who prefer to pay mortgage costs rather than “wasted” higher rental costs, as a rational choice of housing tenure, even where there is uncertainty about when and how a repayment method will be put in place during the mortgage term (this is the group which has, in particular, given rise to regulatory concerns in recent months);
• high net worth borrowers with second homes who can sell their property without risking their main residence;
• high net worth borrowers who have the means to repay the capital through realising assets other than their home; and
• high net worth borrowers who in seeking to manage the liability of their estate to inheritance tax do not want to acquire a significant amount of wealth in a single, illiquid property asset.

Regulatory concerns about systemic risks

The FSA is concerned that existing mortgage customers without a stated or proven repayment method pose a potential prudential risk for individual lenders if a large number of borrowers do not, in fact, pay off their loan at the end of the term, as planned.

The  FSA has a separate, but related, regulatory concern that some consumers have taken on unaffordable mortgages without a realistic repayment method or plan, and there is a drive to ensure that these borrowers should address this situation sooner rather than later. 

Finally, the FSA is seeking to tighten up the broader mortgage rules on assessing the affordability of loans, so its new approach may also affect future interest-only mortgage sales to each of the categories or borrower identified above.

These potential systemic issues have, in fact, been under review within the industry – by the CML with members – since the spring. We will be reporting our conclusions shortly. 

In the interim, however, the FSA, in its July consultation paper on responsible lending, has declared its intention to launch a debate about the future regulation of interest-only mortgages. The FSA says that its aim under the mortgage market review is to create “a flexible market that works better for consumers.” But its likely approach to interest-only mortgages will have the opposite outcome for many of the above customer groups.

The FSA wants to ensure that individual borrowers – as well as being able to meet their monthly interest payments – should have in place a robust plan for repaying all the capital they borrow, and that lenders should be responsible for monitoring that borrowers remain on track to achieve this. The FSA’s current view is that interest-only should be used only where there is a “genuine” repayment method in place, and the consultation paper casts doubt on whether sale of the property should qualify as an acceptable method. The FSA says:

“What we mean by a valid repayment method is a realistic plan to repay the capital that does not rely on house price inflation or unrealistic intentions to downsize to a smaller property at the end of the term.”

We think this goes too far, and fails to take into account the housing choices that borrowers make between home-ownership and renting.

Placing responsibility on the lender to ensure the mortgage capital is repaid "on time" is a significant change in regulatory approach. The FSA’s paper speculates on an enlarged role for lenders in:

• establishing that the borrower has a capital repayment plan in place when taking out a loan in the first place;
• making a judgement on day one that the repayment plan will repay the capital at the end of the mortgage term;
• continuing to monitor (annually) whether the repayment plan is being maintained and (every five years) reviewing whether it remains on course to meet its target to repay the mortgage capital; and
• taking action to address any anticipated shortfall in paying off the capital, including transferring all or part of the mortgage on to a repayment basis without the borrower’s consent.

The FSA has made it clear that it wants to take time to consider the arguments on how to regulate interest-only mortgages. We will be responding in detail with our own review findings at the end of this month. We do not think the approach proposed in the consultation paper is necessary or proportionate for the regulator, lenders or their customers. There is a better way forward.

The impact of the FSA’s proposals

The regulatory reforms the FSA is considering for interest-only borrowing would impose significant cost on firms and individuals. They are likely to significantly reduce the availability of interest-only mortgages, thereby restricting consumer choice. 

Potentially, the costs [of checking annually] and regulatory burden [of lenders taking responsibility for the performance of the repayment method] could lead to the withdrawal of interest-only mortgages from the market. In the prevailing risk-averse lending environment – and with regulators adopting a more interventionist and prescriptive approach – firms will react cautiously to a tightening of the rules on interest-only mortgages. 

Meanwhile, it is far from clear that the costs and the impact of restricted choice for consumers would be matched by any wider benefits.

There is clear evidence that the FSA’s approach has already resulted in more restricted availability of interest-only mortgages. Some lenders have announced they will no longer offer them to first-time buyers, or those wanting to borrow more than £500,000.

Writing about one lender’s decision earlier this year that it would no longer offer any interest-only loans above £500,000, one commentator described such customers as “precisely the group of wealthier, sophisticated borrowers for whom interest-only loans were originally designed.”

And on the lender’s decision to stop offering interest-only loans to first-time buyers, she added: “The danger is that other lenders will follow suit and do away with interest-only mortgages and these young home-buyers will find themselves unable to move house or remortgage to a better deal unless they can afford the higher outgoings on a repayment loan.”

We think this commentary is accurate. 

Conclusion

In the current risk-averse environment – and with the clear prospect of more heavy-handed regulatory intervention – it is difficult to see how a lender could do anything other than take a very cautious view of any investment or savings plan with an uncertain outcome. 

The approach described in the FSA paper is likely to lead to interest-only mortgages being withdrawn from the market. We do not believe lenders will be prepared either to bear the additional costs of regular assessment of the repayment plan, or accept the new regulatory risk that the plan does not achieve its objective at the end of the mortgage term and that the lender will be “blamed” for this outcome. 

In summary, the FSA’s risk-averse approach will have a major negative impact on product choice for UK consumers and the flexibility of the market to meet the needs of borrowers with different income and employment profiles. In our view, the reforms on interest-only mortgages outlined by the FSA risk excluding an option from particular groups of consumers for whom it is a logical choice, and delivers clear benefits. 

Underlying the FSA’s views on interest-only mortgages is a fundamental assumption that owning a property outright is the only outcome that can be desirable or in the interests of the borrower. But, in a complex world, people take out mortgages to meet a diverse range of needs, some of which are already being denied or severely constrained by a shortage of mortgage funding, a risk-averse lending market and tighter regulatory controls. 

The FSA’s desire not to rush to introduce reform on interest-only mortgages is welcome. In our formal response at the end of this month to the FSA’s questions on interest-only borrowing in its consultation document, we will outline changes that we think are more appropriate. We will explain how lender controls could be reinforced without unnecessarily excluding a broad range of consumers from access to a financial product that meets their reasonable needs and aspirations.