Interest-only: coaxing the cat out of the bag
Published: 15 May 2017 | Author: James Tatch
In its 2017/18 business plan, the Financial Conduct Authority (FCA) announced a thematic review of interest-only mortgages, focusing on what happens with these customers as their loans approach maturity. As we look forward to the FCA’s findings, scheduled for the fourth quarter of this year, it is timely to release the key findings from the latest wave of our own annual member survey of interest-only mortgages.
Our survey covers well over 90% of all residential mortgages outstanding, which reflects the industry’s ongoing commitment to effective monitoring to help ensure positive outcomes for interest-only customers.
There are positive findings from our analysis, in particular with borrowers at both the very beginning and at the end of their mortgage term either redeeming or reducing their debt. And, relevant to the FCA’s thematic review, we can also now start to paint a more detailed picture of what happens at maturity.
A healthy, steady improvement
When we first started to collect this data in 2012, the regulatory concern was that interest-only loans may have less certainty of repayment at the end of term than repayment mortgages, and the size of the interest-only book meant that this could potentially be a large problem.
The results from our survey in 2012 sized the interest-only loan book at 3.2 million outstanding mortgages, equivalent to a third of the total residential mortgage stock.
As Chart 1 below shows, the picture has changed dramatically since then, with material year-on-year decreases in the size and proportion of the market that is interest-only.
Chart 1: Residential Interest-only mortgages outstanding
At the end of December 2016, the interest-only stock had fallen to 1.9 million loans, accounting for 21% of all home-owner mortgages. We have now seen four years of fairly steady decline, at a rate of between 10 and 13% a year.
A mostly closed book, but actively shrinking
New interest-only lending still takes place, but is now very much constrained by the affordability framework established by the mortgage market review. Less than 2% of new house purchase loans are now taken out on an interest-only basis, compared to a peak of nearly 40% in 2007. This means the interest-only book is naturally shrinking, driven strongly by the number of loans set to mature each year.
It is, then, an encouraging result that nearly half of last year’s decrease in the book came from loans not set to mature until at least 2028. This contrasts sharply with previous years, where the majority of the decrease in stock came from loans redeeming on maturity.
In another positive movement, the number of interest-only loans at higher loan-to-value (LTV) ratios decreased, most significantly at the longer end of the maturity spectrum. Chart 2 (below) brings these two movements together to demonstrate how the risk profile of the book is improving.
Chart 2: Change in pure interest-only loan book by risk segment, 2015 to 2016
These improvements mean that the interest-only book is in a much healthier position now than in 2012. For example, were house prices to rise over the long term at a historically modest 2.5% a year, only 30,000 loans – or 2% of the current interest-only book – would mature with over 75% LTV. Three years ago that figure was over 100,000 loans.
Lower risk is not the same as no risk…
Even though we continue to see these encouraging improvements in the risk profile, there remains a small, but material, number of higher risk loans. Of most immediate importance, there are 11,000 loans at over 75% LTV with two years or less to run. As Chart 2 shows, although this segment has shrunk in size, the rate of reduction has been slower than for high LTV at longer maturities.
With at most two years to run, inflation can do little to improve the equity position for these loans. Even though this segment represents less than 1% of the book, it is the highest risk – at least with respect to impending maturity and high leveraging. It is, then, crucial that these borrowers either have adequate provision to repay their loans or act now to improve their position.
...and so the industry continues to reach out to customers
Interest-only is not inherently higher risk lending. Rather, it is that, in the absence of ongoing information on ability to repay the principal (as we do have for repayment mortgages), the risk is unquantified. To draw an analogy from another sphere, an interest-only mortgage is like Schrödinger’s Cat – both alive and dead until you open the box and look. Much of the pro-active work the industry has been doing in recent years has been, in effect, to open the box.
In 2014, the industry formalised and has since then monitored and improved its programmes to contact customers with interest-only mortgages. These programmes are designed to make sure that borrowers have adequate plans to repay their loans on maturity. Where such plans are not in place, lenders then enter into a dialogue with the borrower in order to put the loan onto a more sustainable basis.
Overall, lenders initiated a little over half a million interest-only borrower contacts last year, around a third of which were to borrowers with short maturities (occurring up to 2020 or before).
As in previous years, response rates were relatively low but the best success - 20% - was for these short maturities. Of these, more than four in five borrowers had repayment plans in place.
The higher success rate for these short maturities is likely to reflect the risk-based segmentation approaches that many lenders use, directing more of the available resource to those borrowers with the more pressing timelines or other risk factors.
A post-maturity picture is starting to appear, with positive messages
The reduction in size and risk of the interest-only book is obviously good news, as is the finding that most borrowers who do respond to contact have a repayment plan in place. But there are still some borrowers who do not redeem on the maturity date.
What happens to these loans post-maturity is a continually evolving story. Dovetailing with the FCA’s focus on what happens to interest-only loans as they reach and possibly go beyond maturity, our survey data is starting to build a picture of the post-maturity landscape.
In total, lenders have reported around 300,000 loans that did not redeem fully on their maturity date since 2011.
At face value, this looks like a big number. But this can occur for a number of reasons, many of which are very much short term timing issues. For example, some cases will be due to a mismatch of maturity dates between a repayment vehicle and the mortgage itself. Our data suggest that the majority of cases are indeed short term in nature, and redeem without any need for formal intervention.
In a minority of cases, this process is not so smooth and requires more time or intervention.
Lenders work with borrowers in these situations to explore the best route through post-term repayments. Options include contractual fixed term extensions and switching to a full or partial repayment basis. Resorting to litigation and ultimately taking possession is then only necessary when it is the best interests of the borrower because there are no other viable options.
Figure 1 below summarises what our data show on the typical path of loans in the term-expired book.
Figure 1: Typical evolution of term expired loans
For some years, the CML and our members have been pro-active in tackling interest-only issues, an approach endorsed by the FCA in 2014. While praising the work as “a prime example of…good conduct outcomes and putting customers first,” the FCA’s then chief executive, Martin Wheatley, rightly said that it was “too soon to declare success.” So, how are we looking three years further down the track?
We have certainly come a long way, with an interest-only book that is leaner and fitter. Borrowers and lenders have worked together to reduce the size of the interest-only book and de-risk what remains within it. That de-risking has been evident in our data showing an improved LTV profile. But it also shows in ongoing contact programmes that, with each year, work cumulatively to confirm or establish viable repayment plans for an increasing proportion of interest-only customers.
However, there are many borrowers who do not respond to contact. The industry faces an ongoing challenge to increase engagement, by sharing best practice and building on what works,
We also now know more about the cases that do not redeem immediately on maturity, and here we see another largely positive finding that the vast majority of these borrowers do subsequently pay off their loan, either with or without assistance from their lender.
So, is this success?
While our data does not give a precise one-to-one linkage between successful borrower contacts and good outcomes, it does point strongly towards that being so, and discussions within the industry support this, In other words, where lenders employ well-targeted strategies for contact and case management, we are better able to ensure borrowers have appropriate means to repay.
With five years worth of data showing steady improvement, you could make a decent case for now calling this success. But, with 1.9 million interest-only loans still remaining, we would rather say “so far, so good.”
And with a third of the interest-only book not due to mature until the 2030s, it is crucial we continue our commitment to managing developments to deliver the same positive outcomes, so we report the same sort of progress every year. We look forward to the findings of the FCA’s thematic review to help us deliver these outcomes.