How regulation changed interest-only mortgages

The FCA tightened the rules on interest-only mortgage deals in 2014 following the MMR, so lenders have to be comfortable the customer has a credible repayment strategy before providing an interest-only mortgage.  

As a result, there are far fewer interest-only mortgages being provided today than there was previously.

Jaedon Green, director of products and distribution at Leeds Building Society, says the two key things that were introduced as a result of the MMR are: 

• Anybody who applies for an interest-only mortgage is stress-tested at a higher rate than they would pay.
• They are also stress-tested as if they would be making capital repayments.

He explains: “With someone that is using interest-only, there is a misconception they may be using it leverage up, to maximise tier affordability.

"If they could not afford the mortgage on a capital repayment we would not give them that mortgage on an interest-only basis.”

Another change that regulation brought was an onus on the lender to sense check the plausibility of the repayment strategy.

While there is still plenty of room for improvement, the industry is making really good progress in engaging successfully with more and more borrowers. James Tatch

Mr Green adds: “If you take a mortgage with us, the starting point is that I have to ask you, how do you intend to repay this mortgage? It may come across as invasion of privacy to some degree, but we are checking have you got a repayment strategy.

“If you say, I have savings, part of the interest-only regulation requires us to say can you give us proof of your savings and that you are saving regularly.”

“The one we see frequently is where some people say, ‘my intention is to downsize. I may be in a four bedroom detached property, but reality is the kids will leave home and my intention is to downsize to a two- to three-bedroom semi-detached’.”

Mr Green comments that lenders will generally assess the repayment strategy to check its plausibility, using different tools to check the strategy the customer has declared.

Levels of lending

When it comes to the loan-to-value (LTV) available, brokers have said they have seen very few lenders that will offer an interest-only mortgage at above 75 per cent.

Ray Boulger, from John Charcol, says: “Where pre-credit crunch, lenders often did not ask what the repayment strategy was going to be, now they do.

"If the repayment strategy is the resale of the property, lenders have to factor in the ability of the borrower to downsize and as a result of that, the most common way of doing that is for lenders say there has to be a minimum equity.”

In some cases this can range between £150,000 and £300,000.

So the two key restrictions for someone who wants interest-only where the sale of the property is the repayment strategy are a maximum LTV, of between 50 and 75 per cent, but very few lenders go above 60 per cent.

Some lenders will also require a minimum income, sometimes as much as £75,000. Others, like Halifax, where a borrower is using stocks and shares Isa as their repayment vehicle, will want to see that the Isa has adequate funds right now to repay the interest-only element of the lending.

If you take a mortgage with us, the starting point is that I have to ask you, how do you intend to repay this mortgage? Jaedon Green

If the borrower is using their pension as the repayment vehicle, they typically need to have a minimum projected fund value of £400,000 and the lender would look to use a maximum of 15 per cent of that.

One of the other trends Mr Boulger has seen over the last two or three years is where lenders say they will offer up to 75 per cent LTV; this is split between 50 per cent on interest-only and 25 per cent on a repayment basis.

According to data from UK Finance the interest-only book has shrunk and it has also become healthier, according to the mortgage body, in terms of the equity position of borrowers.

UK Finance data shows:

• The interest-only book now stands at 1.7m mortgages and is worth £250bn. This is a little over half the number it was just six years ago.
• In 2012 over 900,000 pure interest-only mortgages – 36 per cent of the total – had an LTV of 75 per cent or greater.
• Last year this had fallen to just 174,000 mortgages, or 13 per cent of the total.

As lenders have worked with borrowers to rectify the situation, In 2014, when these contact programmes first began as a coordinated industry initiative, although many lenders were already operating their own programmes ahead of this, responses rates were around 16 per cent for contacts to borrowers with pre-2020 maturities, and ten per cent overall.  

Number of interest-only mortgage homeowners outstanding

Source: UK Finance 

James Tatch, principal, analytics at UK Finance, says: “Four years later, the data suggests the industry has built on best practice, such that contacts response rates have approximately doubled for near-term maturities, and trebled overall.

"While there is still plenty of room for improvement, the industry is making really good progress in engaging successfully with more and more borrowers.”

There are continuing redemptions of interest-only mortgages, both on and ahead of schedule, to reduce the size of the remaining book much faster.

There are material reductions in numbers of interest-only mortgages at higher LTVs, so that fewer of those remaining interest-only borrowers are constrained in their options by insufficient equity.

And lenders are seeing more success in engaging with their interest-only customer base to assess repayment plans and, in cases where there are none, put viable plans in place.

Room to improve

However, despite these continuing improvements, there are a small number of interest-only mortgages that do not redeem in full on their maturity date. Last year there were 34,000 such “term-expired” mortgages.

For the minority of cases where the borrower cannot redeem in this way, lenders work through a range of options to allow the borrower to repay the loan.

Formal term extensions for a fixed, usually relatively short period, are more common in the first year or two.  

For term-expired mortgages that persist for longer without redeeming, increasing numbers are switched to repayment terms and progressively pay off the loan that way. A number of customers also sell their properties to pay the capital.

However, there are a very small number of cases when, after all options have been exhausted, the borrower has no realistic chance of repaying the loan.  

Data from UK Finance has said the incidence of repossession among term-expired interest-only loans is very low indeed, even in the context of the current benign environment where mortgage possessions overall are near 40-year lows.

ima.jacksonobot@ft.com