Interest-only: lenders are making progress - but there's more to do!
Published: 17 June 2014 | Author: Bernard Clarke
In today’s issue, we set out to provide a comprehensive update on what is happening to the stock of outstanding interest-only mortgages, following our conference on this subject last week. We are also providing more detail on the progress lenders have made in seeking to ensure that as many these borrowers as possible remain on target to pay off their mortgage when they get to the end of their term.
Responsibility for repaying any mortgage rests, of course, with the customer. To help interest-only borrowers stay on track, however, lenders have, for a number of years, been sending a regular reminder to customers encouraging them to keep their repayment plans under review. In cases where borrowers may face a shortfall at the end of the term, lenders are committed to working with them to help overcome their problems.
Just over a year ago, lenders stepped up their efforts to make contact with interest-only borrowers and reinforce the advice that they should continue to scrutinise their repayment plans. The first phase of this strategy – aimed at around one million customers with interest-only mortgages due to mature by the end of 2020 – has now been successfully completed. Encouragingly, the overwhelming majority of borrowers that have responded to this initiative already have in place a credible plan for repaying their loan at the end of the term.
Our research into the interest-only sector has produced a range of encouraging findings, including:
- A 13% reduction in the number of interest-only borrowers in less than a year, from around 3.2 million to 2.8 million. Over a 15-month period up to the end of last year, balances outstanding on interest-only mortgages declined from £424 billion to £363 billion, or by 14%. This rate of decline is more rapid than what we would expect "naturally" as a result of borrowers simply paying off their mortgage as they come to the end of the term.
- Very few new interest-only mortgages are now being advanced (other than in the buy-to-let sector, where interest-only borrowing predominates) while a steady stream of existing borrowers continue to pay off their mortgage at term, as expected. But the rate of decline has accelerated because a proportion of borrowers are taking active steps to make sure they pay off their capital, including switching from interest-only to a repayment option during the term.
- The growth we have seen in the amount of equity held by interest-only borrowers, while the total value of mortgage debt held by these customers continues to fall. For individual borrowers, holding more equity in their property widens their options if they do face a shortfall in repaying their loan at the end of the mortgage term. For lenders, there is reduced exposure as interest-only balances decline while the equity held by borrowers increases.
- A successful outcome to the industry’s commitment to contact all interest-only borrowers with loans due to mature by the end of 2020. And more than four in five of those borrowers who have responded to this initiative have in place a credible plan for repaying their mortgage at the end of its term. We welcome the Financial Conduct Authority's (FCA) view that the 2020 contact strategy has been a “prime example” of activity delivering "good outcomes and putting customers first."
The contact strategy
In May 2013, the lending industry made a commitment to contact within a year all interest-only borrowers with a mortgage due to mature before the end of 2020. The aim of this exercise has not been to force borrowers to take action against their wishes, but to ensure that they are aware of their mortgage repayment position and have an opportunity to act if necessary.
If we add up all those contacted by lenders (either since the commitment was announced or beforehand), as well as those who have paid off their loan or switched to a repayment mortgage since the launch of the communications strategy, and those interest-only customers with only a very small outstanding balance, we believe that lenders have, to all intents and purposes, successfully achieved their objective.
At the start of the exercise, the number of borrowers with an interest-only mortgage due to mature before 2020 totalled 980,000. Of these, 720,000 (73%) have been contacted as a result of the lender communication strategy.
Among this group, 28% had responded to the lender by March this year (that is, before the end of the 12-month campaign). And of these, more than 80% had a repayment strategy in place. Some 6.5% of those responding agreed to change their contractual terms, most commonly by switching to a capital repayment mortgage. Other options lenders may offer to customers will depend on their individual circumstances, but may include extensions to the term or over-payments.
By March 2014, the total number of interest-only mortgages due to mature by 2020 had fallen to 800,000, or by 18%. Much of this decline had been achieved through the "natural" process of loans coming to the end of their term and being paid off, as expected. But we estimate that the number of borrowers opting to switch to a capital repayment option accounted for more than 10% of this decrease.
The improving equity position of interest-only borrowers
When considering the options for interest-only borrowers, it is important to understand the impact of rising house prices on their equity position. Stronger growth in house prices in recent months has reinforced these effects, and contributed to a significant decline in the proportion of outstanding interest-only mortgages held at higher loan-to-value (LTV) ratios.
Factoring in the effects of only modest house price inflation (of, say, 2.5% a year) dramatically improves the equity position of interest-only borrowers, as Chart One shows. And rising house prices do not only have an effect on loans advanced at higher LTV ratios. There is a significant increase in the proportion of these mortgages that will mature at LTV ratios of lower than 75% as a result of rising house prices.
Chart One: Interest-only loans: projected loan-to-value ratio at maturity
Action by borrowers to re-pay their capital further improves their equity position, of course. Our research shows that these effects are spread across the scale, from borrowers with loans at the highest LTV ratio (in excess of 95%) to those who already have much larger holdings of equity.
Lenders will continue the work they have begun as part of the initiative for contacting interest-only borrowers with loans due to mature before 2020. Firms have deployed a range of means of making contact with borrowers, including reminders and mailings requesting a written response, telephone calls, face-to-face meetings and even home visits.
We do not yet have a comprehensive picture of what works best, but there are some broad conclusions that we can draw.
Firms with the best response rates tended to adopt a variety of methods for contacting borrowers. Lenders were also more likely to get a response when they sought action from customers, effectively by requiring them to do something. Firms with higher response rates were also persistent in their attempts to make contact with borrowers.
Some lenders pursued a strategy of intensive activity to get a response from the customers, perhaps through a series of telephone calls in a short period but at different times of the day. Others sent a number of letters and then followed up with telephone calls.
Smaller lenders tended to have some of the best response rates, perhaps because they had a smaller group of customers on which to focus. But some large firms with large numbers of customers also achieved a good level of responses through persistent and well co-ordinated activity.
We have undertaken our own qualitative survey of the work lenders are doing in dealing with interest-only customers. The responses we have received cover around 90% of the market, and have produced some encouraging findings.
Around 90% of firms have a written policy in place for dealing with interest-only customers, which has been approved by senior management. Around three-quarters of these firms have fully implemented that policy. Most have written guidance for staff, and all firms offer a wide range of options for interest-only borrowers, depending on their circumstances.
In tandem with the 2020 communications strategy, we have worked with the Money Advice Service on a practical action plan for borrowers. We have also developed an interest-only toolkit, which lenders can draw upon to help them work with customers to minimise the risk of unexpected difficulties at the end of the mortgage term.
We welcome the FCA’s commendation of the lending industry's communications strategy, coinciding with our interest-only conference last week. FCA chief executive Martin Wheatley said:
"This forward-looking and consumer-at-the-heart type of action is a prime example of a model demonstrating good conduct outcomes and putting customers first. It's good to see real progress is being made.
"What I am particularly pleased with is how industry, regulator and consumer have come together to address this problem as one in a collaborative way. It's too soon to declare success, but these are encouraging findings."
To paraphrase Winston Churchill, a successful outcome to the 2020 communications strategy is not the beginning of the end of the challenges for lenders in dealing with interest-only mortgages, although it may be the end of the beginning. We agree with the FCA that it is too early to declare success overall, but we believe that the findings of our research are encouraging.
Along with individual lenders, we recognise that meeting the objective of the 2020 communications strategy represents only the first steps in an ongoing programme of work to ensure that as many interest-only customers as possible remain on course to pay off their loans.
We agree with the FCA that what has been achieved so far is a good example of the lending industry, the regulator and consumers working collaboratively. But as the FCA went on to say:
"Everyone needs to keep the momentum going. (The) advice for borrowers is unchanged: you must engage with your lender; this is a shared problem and you need to work together to resolve it."
Looking ahead, we will work with lenders to build on the experience they have gained over the past year, to refine and reinforce their contact strategies, to seek responses from borrowers who have not yet communicated with them, and to gain further insight into which methods are most effective in encouraging borrowers to respond.