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Interest-only: onwards and downwards

Analysis

Published: 22 September 2015 | Author: James Tatch

At our interest-only conference today we gave an update on where lenders and borrowers are in managing the stock of existing interest-only loans through to maturity and, where necessary, beyond that point.

It has been more than three years now since the Financial Conduct Authority’s Martin Wheatley suggested that the UK’s stock of interest-only mortgages could be a “ticking time bomb.” Since, then, the industry, and borrowers, have worked progressively to address those concerns.

In our new data, we estimate that, as at the end of 2014, the stock of outstanding interest-only mortgages stood at some 1.9 million loans, with a further 460,000 on a part interest-only, part repayment basis.

As Chart 1 below shows, this represents a fall of 25% in just two years.

Chart 1: Residential interest-only loans outstanding

 Chart 1: Residential interest-only loans outstanding

Source: CML Economics

Notes:

1: Data cover homeowner loans only; excludes buy to let and lifetime mortgage portfolios

Download the data

This is obviously a significant reduction, but one that has to be taken in the context of a book that, since 2008, has seen few new loans flowing into it.  Last year, for example, only 1% of first-time buyers borrowed on an interest-only basis.

So, much of the contraction is due to the maturing profile of a progressively ageing interest-only book, as loans reach the end of term and are redeemed. Our figures show that a quarter of the reduction seen during 2014 is due to this “natural attrition” in the book.

But that also means that three-quarters of the reduction comes from interest-only loans being redeemed ahead of their maturity date. And in fact 40% of the total came from loans that would not have matured until 2028 and beyond.  In most cases, these mortgages would have been converted on to a repayment basis.

Borrowers’ equity has improved

The equity position of the remaining interest-only stock also improved last year.  Part of this was down to house price inflation which, according to the Office for National Statistics, ran at nearly 10% nationally.  However, as Chart 2 shows, inflation on its own would only have had the effect of decreasing the numbers of loans at higher loan-to-value (LTV) ratios, with a compensating increase in the numbers of mortgages at lower LTV ratios. But there were decreases in the number of interest-only mortgages across the board, mostly over and above this “passive” inflation effect.

Chart 2: Change in interest-only loans outstanding, 2013-2014

 Chart 2: Change in interest-only loans outstanding, 2013-2014

Source: CML Economics

Notes as per Chart 1, additionally:

1. Figures cover pure interest-only loans maturing in 2015 and beyond.

Download the data

These improvements in the book, over and above the effects of house price inflation, will be a mixture of early redemptions and borrowers making lump-sum payments to reduce the size of their loan. What is driving these welcome improvements is another question.

Life after the “2020 commitment”

We reported last year that the industry had made good on its commitment to contact by the end of May 2014 all interest only borrowers with loans set to mature on or before 2020.  But, as we said then, this was just the start of an ongoing process to engage with all interest-only borrowers as they progress through the life of their mortgages, to ensure that they are both fully aware of their need to repay and that they have the means to do so.

Our update on the number of borrowers contacted by lenders covers only the nine-month period from last April to December. In that time, lenders contacted a further 427,000 borrowers about their interest-only loans, which equates to around 17% of the total stock. But, whereas the focus last time was on contacting the entire pre-2020 book, lenders have subsequently been able to give more attention to those mortgages with a longer maturity date. In particular, lenders have succeeded in contacting nearly a quarter of customers whose mortgages will mature from 2028 onwards.

However, getting borrowers to engage is still a challenge. Last year we reported that some 28% of pre-2020 borrowers responded to contact from their lender. Response rates varied this year - an overall response rate of 10% may reflect the fact that lenders have been contacting borrowers whose mortgages mature well into the future. It is possible that these borrowers, given that they have many years left to run on their mortgages, may feel less need to engage at this early stage.

Despite the limited response rate, however, the data show that the numbers of interest-only loans has fallen, both for long and short maturities. Borrowers may not be engaging directly with lenders about their interest-only loans, but many are moving away from those terms nevertheless.

How are lenders communicating with customers?

Our survey into the steps some members take to contact interest-only customers showed that approaches are evolving. Some have increased the frequency with which they contact customers further from maturity. One member said that their approach consists of letters and telephone calls that began in the 12 months to maturity. Contact would also be attempted out-of-hours, and a dedicated case management strategy was put in place.

Some members also indicated they are continuing to keep their strategy for approaching customers  under review.  Where a customer has not paid his or her mortgage after the maturity date, there is often much greater use of home visits.

There may be a dedicated team working on cases where the mortgage is not paid on the date expected. Letters are sent and outbound calls made in an attempt to resolve matters and, if necessary, field agents may also be used, particularly if it is difficult to contact the customer or if the customer requests a face-to-face discussion instead of discussing matters over the telephone.

Looking at customers’ accounts at or past maturity, the substantial majority of lenders said that less than 10% of customers reported that they were unable to repay the capital and had not yet agreed a solution with the firm.

Where lenders are making successful contact there are positive signs, with 86% of respondents advising they had a repayment strategy in place.

That is a very encouraging number, and one which is supported by the finding elsewhere in our research that only a very small minority of interest-only loans do not repay on – or very shortly after – maturity. In fact, two-thirds of those loans that did not redeem fully on the maturity date have done so subsequently and generally within three months. This suggests that, in many of these cases, the reason the loan went past term was a mismatch of timing – that is, a short gap between the date at which the mortgage ended and when repayment vehicles – be they savings, investments or other assets – could be realised. It also supports what we know anecdotally, that lenders give borrowers a reasonable period to repay following the contractual repayment date.

Finding a solution

For the remaining one-third that have not repaid within a short period, our data shows that lenders work through a range of solutions with borrowers to manage down their loan. Over half of those borrowers that have not repaid have since agreed a move to a capital repayment basis. For those remaining on interest-only terms, this will either be as a result of a contractual extension to their mortgage term, or a short period in which it continues on an informal basis to allow the borrower to realise funds for repayment (which  is, in most cases, within a matter of months).

However, there is a small minority of customers who have not taken the necessary steps to able to repay on time, or nearly on time. Lenders will always seek to explore every option for such borrowers.  And this is so even in cases where obtaining a court order for possession would be relatively simple. The 900 cases of possession reported in our data since 2011 equates to less than 0.5% of the total number of interest-only mortgages that did not redeem on schedule. This is less than half of the cumulative possession rate seen in the wider home-owner mortgage stock over the same period, and is further evidence of how the industry works – and will continue to work – to help any interest-only borrowers who face these difficulties. Looking ahead, the whole aim of the contact strategy is to minimise the future number of borrowers who face an inability to pay at maturity.