Interest-only lending: its past and its future
Published: 17 October 2012 | Author: Bernard Clarke
Interest-only mortgages are back in the spotlight. At the end of last month, we appeared on the BBC radio programme Moneybox to explain why some lenders are now actively encouraging interest-only borrowers to consider their options and act sooner rather than later to make sure they have adequate plans in place for repaying the capital. Those who have a repayment plan are being urged to continue to monitor its progress, and consider their options for addressing any potential shortfall.
Two years ago, we began working with members to devise an interest-only "toolkit" to help identify and mitigate potential repayment risks. Most borrowers with an interest-only mortgage have a plan in place to meet their repayment obligation, even if it is not recorded with the lender. But having a better understanding of the risks will enable lenders to manage any potential problems more effectively. Our toolkit will help and inform lenders as they develop their own policies and actions relating to existing interest-only mortgages.
Interest-only mortgages have also been in the news recently because of decisions by some lenders to change their approach on this type of lending in the future. Earlier this month, for example, the Nationwide Building Society decided not to offer interest-only loans to new customers (except on buy-to-let transactions).
It is for individual lenders to determine what types of loan to include in their range of products. But some, like Nationwide, have decided that diminished volumes of new interest-only lending have now made this type of mortgage a niche product, and one that does not fit in the range of a mainstream lender. This trend is being exacerbated by the regulatory direction of travel, too.
Most interest-only borrowers do have a repayment plan - even if it is not recorded with the lender
To understand the issues in the interest-only market, it is important to distinguish between loans already advanced to customers, and lending now and in the future. In general, there are large numbers of existing interest-only mortgages that may have been around for some time and are for relatively small amounts in today’s terms. Others are more recent and larger, but will mature in the next decade. There are now only small volumes of new interest-only mortgages being advanced, apart from in the buy-to-let sector.
At the peak of their popularity in the late 1980s, interest-only mortgages accounted for more than 80% of all loans taken out. In an earlier article, we estimated that there are now around 3.8 million interest-only homeowner mortgages outstanding. This year, however, lenders are likely to advance only around 40,000 new interest-only loans for residential house purchase, less than 10% of the total.
Among first-time buyers, the decline in interest-only borrowing has been particularly pronounced. Our latest data shows that only 2% are taking out interest-only mortgages, with 98% opting for repayment loans. Interest-only accounts for a higher proportion of new borrowing by existing owner-occupiers who are moving (10%) and those remortgaging (13%). But most of these customers have held interest-only mortgages historically, and will have adequate plans in place for repaying them.
In the buy-to-let sector, however, new interest-only lending is now on a much larger scale than it is for residential customers. This year, lenders are likely to advance more than 120,000 buy-to-let mortgages, the vast majority of which will be interest-only.
The regulatory approach to interest-only
The Financial Services Authority (FSA) is not seeking to stop all interest-only lending to residential borrowers in the future. But it is proposing regulatory changes that will seek to ensure that repayment plans for new lending are not speculative in nature, and are backed by an identifiable and credible repayment vehicle.
We broadly agree with the FSA’s approach and, in response to its earlier consultation, we proposed that lenders should be required to validate the existence of a repayment plan by an interest-only borrower at the point of sale. The FSA had also proposed that lenders should be required to assess the credibility of individual repayment plans. However, we are concerned that this could be seen by the borrower as an endorsement by the lender that his or her proposed repayment strategy will achieve the desired outcome.
The FSA subsequently acknowledged that it does not expect the lender to predict the future. However, we believe this approach could be strengthened to make clear beyond any doubt that lenders will not be responsible for the performance of a repayment strategy. We believe it is essential that borrowers remain responsible for the maintenance and performance of their repayment plans.
We agree with the FSA’s proposal that, as well as validating the existence of a repayment plan at the outset, lenders should check at least once during the mortgage term that it is still in place. We also agree that this check should be made at a time that would reasonably allow the lender and borrower to agree any remedial action that may be necessary.
Recent decisions by some lenders not to offer interest-only mortgages to residential borrowers in the future reflect a more cautious approach to this type of lending across the industry as a whole. Lenders are responding to the regulatory signals that repayment plans for new lending should not be speculative. Some lenders will no longer advance non-advised interest-only mortgages. Others have lowered the maximum loan-to-value ratio they are prepared to offer to interest-only borrowers.
Who loses out with the loss of interest-only?
We believe that interest-only lending can still be a useful option for some borrowers – even in the residential market. Not all borrowers are the same, and customers with fluctuating incomes, for example, might benefit from the flexibility to pay down capital during periods when their income is high, rather than on a fixed basis.
Others that might benefit from interest-only borrowing are those that value owner-occupation because it delivers benefits that they cannot achieve in the rented sector – security of tenure, for example, and the ability to treat the property as their own – but who do not want to own the property in the long term.
Another group of borrowers for whom interest-only may be a choice are those who prioritise lower payments now over certainty later (and are prepared to accept trading down or trading out of the market as part of their plans).
Interest-only on the buy-to-let sector is now on a much larger scale than for residential customers
It could be argued that the best outcome is for each consumer to make an informed choice, based on their individual circumstance and on realistic plans either for repaying the mortgage or a clear understanding of future options that are not based on owning the property outright. In reality, borrowers have a wide range of needs and desired outcomes from buying a property now and may not welcome regulation that restricts their ability to choose products that fit their needs, where they clearly understand the options. But interest-only should not be about finding a way to meet affordability requirements when there is no clear path to repayment of the principal.
The future of interest-only
The market is continuing to evolve and it remains to be seen how lenders respond to the final rules on interest-only borrowing, which we still await. How consumers respond to a market in which interest-only is only a niche product will also be important. No doubt, many will continue to welcome the certainty of the outcome with a capital-and-interest mortgage.
Not all will welcome the higher costs, however. Repayment mortgages are more expensive, and cannot be afforded by some. And, at the low rates of interest prevailing in today’s mortgage market, the gap between the cost of repayment and interest-only borrowing widens.
Interest-only repayments on today’s average house purchase advance of £120,000 (over 25 years and at a 5% interest rate) would be £500 a month. On a capital repayment basis, however, the monthly payments would be more than 40% higher, at £710 a month. (The effects of lower prevailing rates of interest on costs can be seen if we select a higher interest rate, say 10% – the sort of rate that might have been paid by a borrower a generation ago. At this higher rate, monthly capital-and-interest repayments would only be 10% higher than the interest-only option.)
Only 2% of first-time buyers take out an interest-only mortgage - the other 98% opt for repayment loans
What the regulator is keen to avoid, of course, is borrowers selecting, on the basis of cost, an interest-only mortgage for a home they eventually want to own outright without having a realistic plan for paying off the capital. We agree that this is not a choice consumers should make.
The interest-only “back book”
As we noted in our earlier article, interest-only mortgages were popular historically partly because there was tax relief on the premiums on endowment policies that many borrowers took out as a means of repaying the loan. The rate of inflation was also high – and this eroded debt quickly and incentivised borrowers to postpone the repayment of it. But the popularity of interest-only mortgages steadily declined in the 1990s and 2000s, as the rate of inflation fell and tax relief on endowment premiums was abolished.
When we consider the "back book", we need to remember that this includes a mix of interest-only borrowers who will differ depending on the length of time they have left until their mortgage matures; their age; their income; the level of equity they hold in the property; their level of savings and other financial assets; and their future plans.
Existing interest-only borrowers will therefore have different needs and concerns, and potential problems and solutions, depending on their individual circumstances.
Many existing interest-only borrowers will already have a savings plan that will produce a sum large enough to repay their mortgage. Even where the lender does not know about a borrower’s repayment plans, a significant proportion of customers will have endowments, pensions, ISAs or other savings with which they are planning to re-pay the mortgage. Some may have other assets that will enable them to repay. Others may be planning to sell the property to repay the loan.
For those who do not have an adequate repayment plan, one option may be to switch to a repayment mortgage to make up any shortfall. Over the years, a number of customers have successfully chosen to do this.
Every year, lenders contact interest-only borrowers to remind them of their responsibility to repay the mortgage at the end of the term. Lenders want to help borrowers avoid shocks if possible, and some have been reinforcing the annual reminder by writing to borrowers, encouraging them to review their plans.
The number of existing interest-only borrowers who find they are unable to repay their mortgage at term is likely to be small. Even if a borrower faces a potential shortfall, the debt is likely to have been eroded significantly over time, relative both to the income of the borrower and the equity held in the property. However, we urge borrowers in this position not to be complacent, and to talk to their lender, who may be able to direct them to specialist advisers if necessary.
Over the last 30 years or so, interest-only lending has evolved from being the choice of the majority of borrowers to a niche section of the market. More recently, this trend has been reinforced by regulatory intervention, the broad direction of which we support.
Most new interest-only borrowing is in the buy-to-let market, where this option remains the norm for very good reasons. Fixed-rate interest-only mortgages minimise costs for landlords and are more likely to produce a profitable margin. Interest-only mortgages also enable landlords to meet lenders’ requirements that their rental income produces an average minimum cover of 125% of their borrowing costs.
Many existing interest-only borrowers already have adequate plans for repaying their mortgages at term. The key message for borrowers is that they review and continue to monitor their savings plans. Two-thirds of existing residential interest-only mortgages are due to mature after 2020, so there is still time to act for those who may be facing a shortfall. Lenders will help borrowers in this position by explaining the options available and helping them seek advice about their repayment plans if necessary.