Is interest-only really a ticking time-bomb?
Published: 28 March 2012 | Author: Bernard Clarke
At the Treasury Select Committee two weeks ago, Martin Wheatley, the incoming head of the Financial Conduct Authority (which will be the regulator responsible for consumer protection when the Financial Services Authority is dismantled) referred to the sizeable stock of outstanding interest-only loans as a "ticking time bomb".
Such a phrase may evoke worry for some borrowers with interest-only mortgages, especially if they have not been pro-active in managing their plans for repaying their mortgage. But the CML and lenders are actively working, in consultation with the Financial Services Authority (FSA), to identify and implement useful steps to help interest-only borrowers. Action will be focused on ensuring that there are targeted communications programmes with interest-only mortgage borrowers, to enable them to take action as necessary to avoid unexpected shocks when their mortgages mature.
Indeed, the FSA said in its most recent mortgage market review consultation paper: "We also welcome and support initiatives such as the CML's work with its members to identify appropriate methods of assisting existing interest-only borrowers who may not have sufficient means to repay the capital by the end of the term. In doing this it seeks to ensure that those borrowers who actually experience a capital repayment shortfall are treated fairly, with repossession remaining the last resort".
In this article, we unpick what the picture of the interest-only mortgage market looks like. We look at the profile of the interest-only mortgage stock, the past and present influences on the interest-only mortgage market, the regulatory backdrop, and the future.
Why do interest-only mortgages exist at all?
Interest-only mortgages have a long history, but the influences on which consumers choose them, and why, have changed over time. Back in the 1970s and 1980s, there was a strong incentive for consumers to choose an interest-only mortgage backed by an endowment policy as the intended repayment vehicle, partly because tax relief was available on endowment premiums, and partly because inflation (and earnings growth) was high.
In a high-inflation environment, the rationale for postponing the repayment of debt makes sense. In 1971, the average price of a house was £5,442. Twenty five years later, in 1996, the average house price had risen to £68,533, nearly a 1,200% increase in house prices over that 25-year period.
Over the same period, average earnings rose from £1,358 to £15,502 – again, an increase of over 1,000%. With an interest-only mortgage, the real size of the debt at term is far lower than at the outset, and during the high inflation decades this factor alone made interest-only a logical choice for many.
In the lower-inflation decades of the 1990s and the 2000s, the benefits of postponing the repayment of debt were no longer so clear-cut, and tax relief on endowment premiums had been abolished in the 1980s. However, during these decades house prices shifted from around four to five times earnings throughout the 1970s and 1980s to six to eight times earnings in the 1990s and 2000s. There was also a notable shift in employment patterns away from "traditional" waged employment to more flexible working and less predictable monthly earnings flows.
In this environment, interest-only was still attractive to many consumers who valued it as a "flexible" feature that provided a mechanism for consumers to minimise their monthly contractual repayment obligations, while allowing them the flexibility to pay down debt more sporadically, in line with many people’s less predictable cashflows.
How many interest-only mortgages are there?
In the summer of 2010, as part of the CML’s work with the FSA on the mortgage market review, we conducted a survey of our members’ existing interest-only loan portfolios. This yielded data on some 85% of total outstanding lending at that time. We have grossed up our results to estimate the total market, and we have now also updated our analysis to take account of mortgages that have been paid off and taken out since 2010.
Because we have used additional data to estimate changes in the period since the initial survey, the figures presented have a wider error margin. Although we account for interest-only lending in that intervening period we cannot identify what other "unscheduled" actions that affect the interest-only profile may have occurred. Such actions include additional borrowing or unscheduled repayments, and switches to and from interest-only, whether as a result of lender forbearance or personal circumstances. These unknowns may affect both the size and profile of the interest-only book in both directions. However we believe that our figures present a good approximation of the interest-only book as at the end of 2011.
According to our analysis, there are around 3.8 million outstanding homeowner mortgages on an interest-only basis. Of these, two thirds are set to mature after 2020. In the meantime, the number of interest-only mortgages set to mature each year is between 131,000 and 158,000. This compares with around 6.1 million capital-and-interest owner-occupier mortgages currently held by UK consumers.
The table below gives the year-by-year maturity profiles.
Table 1: outstanding homeowner interest-only loans by maturity
The interest-only loans scheduled to mature in the next few years are, on average, comparatively low value. This reflects the fact that the majority of these loans will have been taken out 20 to 30 years ago, when house prices were lower. Even though some households may have withdrawn equity since then, the level of equity withdrawal looks to have been relatively modest for this older interest-only book.
As the chart below shows, the majority of interest-only loans maturing throughout this decade have a comfortable equity cushion. For loans maturing over the next three years, over half have an equity stake of over 70% of the property value, and a further third have a stake of more than 45% of the property value. At the other end of the scale there are very few mortgages with smaller equity stakes due to mature in the next three years. In total we estimate there are 6,000 interest-only mortgages - just 1% of all interest-only loans due to mature over that time – with less than 10% equity.
Chart 1: Equity stake profile of maturing interest-only mortgages
It is also likely – although our data cannot identify this – that a significant proportion of these loans have an accompanying repayment vehicle such as an endowment, pension or ISA. And some borrowers may have other sources of funds to repay the debt, such as savings or inheritance.
Overall, we therefore think that the "ticking time bomb" is overstated as a description for the vast majority of interest-only mortgages due to mature in the next few years.
What about borrowers who don’t have a clear repayment strategy?
Lenders send annual reminders to all interest-only borrowers to alert them that they have a responsibility to plan how they are going to repay their mortgage when it matures. However, lenders face the risk that borrowers may not read such reminders, may ignore them, may not know what action to take or may simply take no action at all.
The proportion of borrowers unable to repay their mortgage at term is likely to be small, but difficult to quantify. Depending on what happens to house prices before their mortgage matures, they may see the real value of their debt eroded and their equity increased, irrespective of any additional steps that they take to pay down capital. But it would be unwise to rely on this as a repayment strategy that will result in sufficient equity being available to them for them to buy a smaller property on the basis of the sale proceeds after the loan is repaid.
Of course, some borrowers may in any case not wish to sell their homes to repay their loans. For these borrowers, it is particularly important for them to undertake a regular review of their repayment strategy, to see if it remains realistic or whether further action is needed.
Lenders want to help borrowers avoid the outcome of having to sell their homes to redeem their mortgages if they do not wish to. The CML and lenders have been actively thinking about what else they can do to help and encourage interest-only borrowers to take action to ensure they know what they need to do to be in a position to redeem their mortgage when it matures.
As a result, CML lenders have worked collaboratively to consider how and when they might contact interest-only borrowers pro-actively to discuss their repayment plans, what tools they can use to address those cases where borrowers currently have inadequate provision for repayment, and what alternatives to full repayment might or might not be appropriate for different types of households. The aim is to be consistent with the new FSA requirements emerging from the mortgage market review that will require lenders to undertake a review contact at least once during the mortgage term on new interest-only mortgages.
Last week, the Co-operative Bank, for example, launched a communications campaign for all of its interest-only borrowers who have 10 years remaining on their mortgage term to make them aware of the options available. It announced a contact plan for all interest-only mortgage borrowers no matter how long is left on their mortgage term, and said it would be waiving all fees for interest-only borrowers who wish to extend their mortgage term or switch to a repayment mortgage.
What next for interest-only?
It is fair to say that regulators, lenders and consumers themselves have all become more cautious about interest-only as the basis for new lending. Under the FSA’s mortgage market review proposals, there is an increased focus on the need for repayment strategies on new business not to be speculative in nature, which the CML supports. There has been much coverage recently of various lenders reducing the maximum loan-to-value limits on which they are prepared to offer interest-only loans to home-owners. And it is notable that, in 2011, 96% of all new loans to first-time buyers were on a capital-and-interest repayment basis – the highest-ever proportion, and a significant contrast to the peak of the interest-only market in 1988 when only 12% of first-time buyers took a repayment mortgage.
This does not mean that the considerable benefits that interest-only loans offer for some circumstances – or the difference that underlying market and economic conditions can make - should be overlooked. While a 25-year £100,000 capital repayment mortgage at 5% will have paid down capital of nearly £11,600 in 5 years, the equivalent capital paid down after the same period at a rate of 10% would be only £6,200. In effect, higher inflation and interest rates make interest-only relatively more attractive, while low inflation and interest rates make it relatively less attractive.
For the buy-to-let market, interest-only is the norm because minimising borrowing costs maximises the net yield and best supports the buy-to-let business model. And for households with erratic incomes who like the flexibility of paying down capital sporadically rather than on a fixed schedule, there can be real benefits. But the discipline required on the part of the borrower to ensure that a long-term repayment strategy is in place and kept on track, and the potential issues for the lender if the borrower does not do so, probably mean that interest-only lending will in future be a niche, rather than mainstream, form of mortgage borrowing.