Regulation’s impact on the interest-only market

According to Andrew Montlake, director for Coreco: “There are a host of different reasons for the lack of new interest-only mortgages but fear of regulatory sanction does play a part.”

Martin Wheatley, the former chief executive of the FCA, said at a conference in 2012 he was concerned about the swathes of people with legacy interest-only mortgages, who may not be able to repay the debt when the loan matured.

Within a year, the FCA published its findings into the interest-only mortgage market. This comprised a 49-page report, Residential Interest-Only Mortgages from Experian, and a 149-page report by GfK, called Interest-Only Mortgages - Consumer Research.

The findings included:

■ By 2020, approximately 600,000 borrowers will see their interest-only mortgage mature.

■ About 90 per cent of all interest only borrowers have a repayment strategy (many of these borrowers will have had a mortgage linked endowment policy).

■ Just under half of all interest-only borrowers are modelled as likely to have a shortfall.

■ A third of the 2020 shortfalls are expected to be more than £50,000.

This regulatory attention, coupled with an already squeezed lending market in the wake of the financial crisis, led to tighter restrictions being imposed as part of the 2014 Mortgage Market Review (MMR)

In the MMR, which came into force on 26 April 2014, the regulator made sure lenders would only provide new interest-only mortgages to borrowers who could prove a repayment plan.

This followed the guidance set out by the previous incarnation of the regulator, the Financial Services Authority, in December 2011, within its proposed package of reforms for the mortgage market.

Among other strictures, such as stress-testing the loans, the proposals included the following: “Customers can borrow an interest-only mortgage as long as there is a credible repayment strategy”.

In the event, many lenders decided until the MMR came into force, and full guidance was available, it would be more expedient to hold off on interest-only lending.

But the FCA has claimed the measures were never intended to cause a contraction in the market, only to usher in a sensible lending strategy.

According to a spokesman for the FCA: “Our rules allow firms to lend on an interest-only basis. We recognise this type of mortgage can be appropriate in a wide variety of circumstances, so we do not dictate whether particular customer types should or should not be offered an interest-only mortgage.

“We do not want consumers to enter into interest-only mortgages, stretching the amount they can borrow, without either being able or having considered how to afford to repay the capital at the end of the term.

“Our responsible lending rules require firms to evidence an interest-only customer has in place a clearly understood and credible repayment strategy.”

PRA and stability

The Prudential Regulation Authority (PRA) has also made several pronouncements about the potential for systemic risk with interest-only and income-only mortgages, giving special powers to the Financial Policy Committee to monitor and quantify their risk to the UK economy.

In 2015, it highlighted possible risks over buy-to-let lending which had been done on an interest-only basis.

Moreover, in April this year, the Prudential Regulation Authority issued consultation paper CP12/16, Supervising building societies’ treasury and lending activities.

According to the paper: “Societies need to recognise the risks involved where they lend on an interest-only basis – and in particular that, on maturity, the borrower may not be able to dispose of the property or refinance the loan and so repay the capital amount lent.”

This regulatory scrutiny has affected borrowers, their advisers, and the product providers.

Indeed, the regulatory attention has brought home to lenders and advisers the fact interest-only mortgages are only suitable for some, not all clients, and the necessity of having a sensible repayment strategy.

According to Roland McCormack, intermediary director for TSB, this scrutiny from on high did stimulate the market contraction. He says: “Many lenders initially responded to regulation by withdrawing interest-only products and raising income requirements.”

Charles Haresnape, group managing director of mortgages for Aldermore, adds: “All lenders recognise their regulatory obligations and are aware of the effect legislation has had.

“Different lenders will have varied approaches to interest-only depending on their strategy.

“However, while individual lenders may approach interest-only differently, it is widely recognised these products will only be suitable for particular customer groups.”

However, respondents to this guide believe a natural knee-jerk reaction to toughen up and tighten up due to the FCA’s stress-testing and affordability rules will give way eventually to more measured lending decisions.

“It is all about lenders getting comfortable with their own exposure limits, but over time I expect most lenders will adopt a sensible interest-only policy once more”, Mr Montlake adds.