Does interest-only lending have a future?
Published: 14 February 2012 | Author: Bernard Clarke
Last month we gave our initial views on the FSA’s mortgage market review (MMR) consultation paper, published in December. We said that the new rules proposed in the latest MMR consultation paper demonstrate that the FSA has listened to us. This month we are looking more deeply into an aspect of mortgage lending that has changed considerably since the financial crisis – interest-only mortgages.
The CML’s work on interest-only mortgages has been varied and far reaching. In 2010 we put together a working group of members to develop an industry position that would fulfil the FSA’s expectations without constraining the market too far. In December’s consultation, the FSA expressly thanked the CML and the working group for providing "helpful market input as we developed our proposals". Lending on interest-only mortgages is still likely to be impacted when the rules come into force.
The original consultation paper and our response
In the original MMR responsible lending consultation paper (CP 10/16), published in the summer of 2010, the FSA outlined its views on the future of interest-only mortgages. We believed their initial thoughts were too onerous and would result in the withdrawal of most lenders from this part of the market.
The FSA suggested that lenders should:
check that there is a valid repayment method in place at the outset of the mortgage; and
monitor the existence and adequacy of the repayment method through regular inspections throughout the life of the mortgage. This could happen through checking on the continued existence of the repayment method, perhaps on an annual basis, with the adequacy of the method checked, say, every five years.
We agreed with the first statement. But the second meant that every year lenders would need to contact every borrower with an interest-only mortgage. In the response we submitted to the consultation, we queried how this could work. The lender would need to write to each customer, requesting proof of the repayment method. They would also need to chase with more letters and telephone calls if there was no response or inadequate proof was provided. They would also need to run anti-fraud checks to confirm that the proof provided was real.
Then, they would also have to check that the repayment method chosen by the borrower was performing adequately every five years. Making the lender effectively responsible for performance of the repayment method could lead to the borrower ignoring its performance. And if there was a capital repayment shortfall at the end of the term, the borrower could believe that they could legitimately make a claim against the lender, as they will consider it to have been the lender’s responsibility to identify and mitigate any potential lack of adequacy.
We believed this level of lender oversight was too complex and costly which is why it would likely result in the withdrawal of most lenders from the interest-only market.
In our response, our alternative suggestion was for the lender to collect proof that a repayment method exists at the point of sale. Then, once in the life of the mortgage they would re-validate the existence of the repayment method.
In order to ensure that the lender was not perceived to be taking responsibility for the performance of the repayment method, we suggested there should be an additional declaration in the KFI and/or mortgage offer. It should state that the customer retains responsibility for the repayment of capital and therefore the performance of the repayment method.
The new consultation
The paper published before Christmas (CP 11/31) included an amended set of proposals for new interest-only mortgages, which are broadly aligned with our response in 2010. We welcome the changes that the FSA has made and the recognition that interest-only mortgages remain an appropriate choice for some borrowers.
The FSA proposes that:
lenders must obtain evidence of the repayment strategy before entering into the mortgage, and that they lend only where, as far as they are reasonably able to assess, it has the potential to repay the mortgage.
We agree with this as it formed a key part of our original response.
We welcome the flexibility for lenders to determine when and how to check the repayment vehicle mid-term. The FSA says:
We are proposing that lenders must strengthen their management of interest-only lending over the mortgage term, by requiring the lender to contact interest-only borrowers at least once during the term of the mortgage, to establish whether a repayment strategy remains in place…
What the FSA does not do is say when that must happen, but leaves it up to lenders to take advantage of "natural contact points" where the lender is likely to contact the borrower for another reason or vice versa. The stipulation is, though, that the contact must come early enough before the end of the term that, if necessary, steps can still be taken to address the situation.
The FSA does go further than our 2010 response on the following point though. The end of the above paragraph states that "it is still reasonable to expect that it (the repayment strategy) has the potential to repay the mortgage."
This is a key issue for lenders, as we stated in our response, as they do not want to be seen as responsible for the performance of the repayment vehicle. The FSA rightly suggests that:
there is value in being alerted to potential issues when there is at least some time to consider remedial action, rather than waiting until the end of the term where options may be even more limited.
Lenders are still concerned about this. There is a risk that borrowers believing that, because the repayment strategy has been checked and cleared by the lender, it will 'definitely’ repay the capital. If the repayment method fails to perform adequately by the end of the mortgage term the borrower may believe that the lender is liable. The FSA clearly states that "the repayment of a mortgage is the ultimate responsibility of the borrower". But borrowers and the Financial Ombudsman Service will need to clearly understand that despite lenders having to assess the probability of the chosen repayment method meeting its target, borrowers, not lenders, will actually be responsible for the repayment method they choose.
What will make a suitable repayment strategy?
The FSA has decided not to tell lenders what should be a suitable repayment strategy, but rather, to a degree, allow the lender to choose based on each customer’s individual circumstances. Examples of suitable strategies are:
regular savings into an investment product;
sale of other assets, such as property or other land owned;
periodic repayment of capital from irregular sources of income (such as bonuses or some sources of self-employed income);
on death, for example in the case of a lifetime mortgage; or
sale of the mortgaged property, where this is a credible strategy because of down-sizing or repayment at death.
There are caveats though. The strategy must be appropriate and "credible given the circumstances of the consumer". It has also stated that purely speculative options, such as relying on house price growth and potential future inheritance should not be allowed.
Selling a primary residence and downsizing will only be classed as a credible strategy if the lender can confirm there will be enough equity to pay off the capital and buy another property. We believe this will lead to much larger deposits needed in this situation making it likely to be restricted to higher value properties only.
In its headline to the MMR consultation, the FSA stated that its aim was to "put common sense at the heart of mortgage lending." The proposals surrounding interest-only lending are certainly more sensible than originally planned but they will still constrain this part of the market.
By reducing the onerous requirement for annual checks on a borrower’s repayment strategy, the FSA has made it less likely lenders will pull out of the market. But lenders will still need to restrict the types of vehicles used for repayment purposes and ensure whatever repayment strategy is in place has a reasonable chance of paying off the capital. This will still give many lenders cause for concern, despite the FSA making it clear that borrowers, not lenders, will ultimately be responsible for the repayment of the capital.
But these proposals will do exactly what the FSA intends them to do – allow interest only to exist as a niche part of the market, but not as an everyday choice for borrowers.