Interest-only jitters

21 June 2010 | By Christine Toner

With lenders changing their criteria in the past two years more often than David Beckham changes hairstyles, one would expect brokers to be almost nonchalant about it by now. But that wasn’t the case recently when Lloyds Banking Group announced changes to its interest-only deals. Far from taking the news with a pinch of salt the industry was gripped with concern. Did this mean time was running out for interest-only mortgages?

Earlier this month Lloyds group announced that borrowing of more than £500,000 will only be available on a repayment basis as part of a strategic review of its interest-only products.

It also decided that interest-only borrowers must have valid repayment vehicles in place. The sale of a main residence or other assets including a business will no longer be accepted as proof of repayment, nor will inheritance.

Lloyds group’s Halifax brand has a maximum loan size of £7.5m, meaning that before the £500,000 cap was introduced borrowers could theoretically take out loans of up to £7.5m on an interest-only basis.

When the announcement was made brokers spoke to Mortgage Strategy of their concern.

“Lloyds group seems to be trying to stamp out interest-only deals,” Aaron Strutt, broker with Trinity Financial Group, said at the time. “It’s certainly making a good job of moving new borrowers onto repayment deals.”

Lloyds group wasn’t the first to make such a move. In 2008 Abbey for Intermediaries reduced its maximum LTV for interest-only deals from 85% to 75%.

Given the size of the group and its market share the industry has been left wondering whether this is the final nail in the coffin for interest-only. But Abbey for Intermediaries says that from its perspective, interest-only still has a place.

“No, it’s not the end,” says Phil Cliff, mortgage director at Abbey’s parent Santander. “Our maximum LTV on interest-only mortgages is 75% and has been since April 30 2008 when we reduced it from 85%. There is no maximum loan size - it depends on the maximum allowed on individual products. Most deals are up to £550,000 but we have some products up to £1m. We have no plans to change our policy on this.”
And Nigel Stockton, sales director at Lloyds group, is also keen to get this point across.

“We are still offering interest-only where it’s appropriate across all our brands,” he says. “The changes we have made as part of our review are to ensure our interest-only offering reflects the additional risk involved.”

Stockton adds that with interest-only there’s no guarantee that the total loan will be repaid at the end of the mortgage term.

“Of course, this is guaranteed with a repayment mortgage,” he says. “But because there’s an additional risk and more responsibility associated with interest-only we have to ensure our pricing reflects this. So interest-only is still available but it’s priced around 0.2% higher than repayment products.”

And despite initial scepticism, many in the industry have been comforted by lenders’ reassurances. Indeed, some believe that far from following in the footsteps of the likes of Santander and Lloyds group, some lenders may promote interest-only now.

“I think we will see some lenders using this as a tool to win market share,” says Robert Winfield, managing director of Chartwell Funding. “In my experience clients would be prepared to pay an extra, say, 0.25% on their rate for interest-only so it’s good for margins too. This was how it was in the good old days before the credit boom and easy money. I expect Lloyds group to have only one of its brands offering interest-only in due course, keeping the rest safe to appease the regulator. This will be a bit like the good bank/bad bank scenario at Northern Rock.”

Winfield says this attitude is common in Europe and the UK should adopt the idea of leaving houses and mortgages in wills.

“A long-standing interest-only loan will be at a great LTV and low risk,” he adds. “So if you pay interest for life and clear the loan when you die your lender will have made more than if you had taken out a repayment loan. And after all, that’s why lenders are in business - not to dance to the regulator’s tune.” The Post Office is one lender that seems to be living up to Winfield’s prediction of promoting interest-only. It has taken a different stance from Lloyds group, making a range of 90% LTV deals available on an interest-only and capital repayment basis.

But Tony Ward, chief executive of Home Funding, believes interest-only mortgages only have a future if lenders ask the right questions when granting them.

“This will prevent mis-selling scandals later on and the danger that at the end of 25 years borrowers might be evicted,” says Ward. “A halfway house would be to underwrite a loan as if it were interest-only, as suggested in the Mortgage Market Review. But I don’t like that idea much - it would not guard against the inability to repay further down the road if a borrower fails to save, while if they are already saving it would penalise them.”

Of course, the main reason for the decline of interest-only mortgages is the lack of funding available. Funding has been tight since the credit crunch hit and, as Stockton pointed out earlier, given the added risk that comes with interest-only deals funding them is even more difficult.

“Interest-only means that no repayment vehicle has been identified,” says Ward. “Until the mid-1990s these deals tended to be used when a repayment vehicle was known - usually an endowment policy that was assigned to the lender or a pension.

“After that lenders did not take assignments and eventually stopped asking how loans would be repaid. This was not a great idea and simply stored up trouble for the future. This history makes such loans even more difficult and expensive to fund now, given the prevailing uncertainty in the financial world.”

Cliff agrees, saying capital repayment mortgages leave no doubt about how the principal will be repaid at any time in the life of the loan. “As a result, interest-only is a product for creditworthy customers only - those who can be relied on to follow through on repayment strategies that are sometimes pretty complicated,” he adds.

Stockton says it is important to be clear that interest-only has not suddenly become more risky, nor has Lloyds group seen more individuals unable to repay at the end of their mortgage term.

“We have seen a rise in the number of borrowers selecting the interest-only option which means this is a good time to ensure our policies and products are appropriate - that’s why we’ve made some changes,” he says.

Alongside its pricing changes Lloyds group has reviewed which repayment vehicles are acceptable to ensure customers are better able to keep track of their repayment plans and review them on a regular basis.

“One of the options we’ve removed is sale of the mortgaged property - borrowers should never rely on the sale of their home to repay capital,” says Stockton. “It’s all about ensuring that pricing reflects risk.”

And risk has been the buzz word for some time now. But while lenders admit they have to minimise their risk most are aware of the need for a product such as interest-only to help first-time buyers get on the housing ladder.

“Interest-only can be a valid option for some borrowers and we want to maintain consumer choice,” says Stockton. “In fact, the changes we’ve made are to ensure that it remains an option where appropriate.”

According to Winfield, such loans are crucial.

“Aspiring first-time buyers need interest-only or they will have to live in rented accommodation,” he says. “Interest-only loans didn’t cause the credit crunch - 90% LTV self-cert and adverse loans did, and these should never be compared with interest-only.”

And Winfield says the current generation of buyers is even more suited to interest-only deals than previous ones.

“Interest-only deals are a must for first-timers, especially as this generation mostly have parents and grandparents who own houses and this wealth will filter down,” he adds. “Too much energy is wasted worrying about this topic when other areas are considerably more risky. We need to invest in the future and offering interest-only is one way of keeping the property escalator moving.”

Industry consultant Mehrdad Yousefi says the restrictions imposed on interest-only mortgages by a number of lenders recently are sensible at first glance but they have the potential to affect the house purchase market in some parts of London and the South-East.

“Given that there are still limited funds available for lending and there are not enough lenders operating to stimulate competition many borrowers will find it difficult to secure affordable mortgage deals,” he says.

“This is because most will have to find a 25% deposit to get a competitive rate. Moreover, many individuals living in London and South-East will need to borrow between 3 x and 3.5 x income to buy even a modest property in the £180,000 to £270,000 range. If they have to pay on a capital repayment basis in the first two or three years many will not pass lenders’ affordability tests.”

Yousefi says that in central and greater London, once you look beyond cash buyers and foreign nationals, a consumer would have to earn an above-average salary of £40,000 to afford a mortgage of, say, £120,000 or £135,000 which is 3 x or 3.5 x salary on a repayment basis in the first few years. So with the virtues of interest-only clear, what could lenders do to help first-time buyers in light of criteria changes that could leave the most needy beyond the reach of the product?

“It’s important that customers should have a choice where appropriate, but also that this choice accurately reflects the additional risk of the product,” says Stockton.

“Interest-only has been cited as a way of helping first-time buyers because of the reduced monthly payments but when you factor in the cost of maintaining a repayment vehicle it’s not always true to say it’s cheaper.

“Like all borrowers, first-time buyers need to regularly review their repayment vehicles and ensure they’re on track,” he adds. “We’re committed to supporting first-timers with products that are appropriate. The changes that we’ve made to interest-only don’t alter that commitment.”

And Cliff says Santander too is always looking at ways to help first-time buyers.

“For instance, we have our Homebuyer Solution which offers first-timers and remortgage customers free valuations and £250 cashback to help with costs,” he says. “And in recent months we have also increased our maximum LTV on new-build properties, offering 80% LTV for flat buyers and increasing this to 90% LTV for house buyers.”

While neither Lloyds group nor Santander cite the credit crunch as the primary reason for changing criteria one wonders whether an improvement in the funding situation might prompt either lender to revise their changes.

“This is the right time to review interest-only, given its increase in popularity among new borrowers,” says Stockton. “As with any lender we will always review our policies in line with the market to ensure they are appropriate.”

Cliff is equally vague, saying that the lender is comfortable with the measures it has in place for interest-only lending and has no immediate plans to change these.

“We will track developments in the market and review our strategy on an ongoing basis,” he adds. “This is not a matter of market conditions or funding, it’s a matter of maintaining a prudent and resilient lending strategy.”

Given the turbulence the market has experienced it’s not surprising that lenders’ attitudes to risk have changed. But interest-only mortgages have long offered first-time buyers a chance to purchase a home in an otherwise hopeless situation.

If lenders put these deals beyond the reach of first-timers now it would be in everyone’s interests for them to come up with a viable alternative to prevent aspiring home buyers being driven even further from the market.

 

Still a place for interest-only

Robert Sinclair
director
Association of Mortgage Intermediaries

In its Mortgage Market Review the Financial Services Authority voiced concerns about interest-only lending. In its early briefings the regulator set out its view that the increase in the popularity of interest-only loans had allowed individuals to borrow more and fuelled a property price bubble that might not otherwise have occurred.

Recently there has been concern about how outstanding capital amounts will be repaid. Where there is an agreed repayment source that is certain or quantifiable, this might be safe. But are inheritance, the sale of the property or downsizing realistic options in an environment of parents living longer, higher long-term care costs and pressure on retirement incomes?

The overhang of endowment complaints means few advisers will have been comfortable recommending a saving or investment vehicle alongside a mortgage. Indeed, I suspect few actuaries would like to stake their pensions on the returns on an investment strategy outperforming the likely longer term interest charges on a mortgage loan. Some 30 years ago, in a world of Mortgage Interest Relief at Source, lower value loans, lower LTVs and higher equity exposure in most funds this must have seemed like a balanced risk. But is it true today?

In my view, there is still a place for interest-only and I don’t think many at the regulator would dispute this. Interest-only could:

• Form part of an Inheritance Tax planning strategy.
• Assist in the early days of loans, with conversion to capital repayment within, say, three years.
• Assist in cases of financial hardship or cover temporary funding issues.
• Be used where there is a genuine likelihood of rising income or regular large bonuses.

So although we are seeing lenders limiting their exposure I see this as part of moving back to a more sensible market.

Some lenders seem to have much more interest-only borrowing on their books than their management would like. In the longer term, if the Retail Distribution Review of investment markets produces a system of simplified advice the mortgage sector might find a way to deliver simpler repayment vehicles. In future, lenders will want to know tangible and credible repayment plans are in place.

Also, lenders’ back books will need addressing. They will have to ensure that interest-only borrowers who can’t afford to move to repayment start savings schemes or have a plan to cut their debt.

But we must avoid pushing good customers into positions that lead to distress. A team approach is required and brokers are ideally placed to work with lenders and borrowers, developing ideas that deliver beneficial outcomes both parties.

A knee-jerk reaction won’t help

Dale Jannels
sales and marketing director
All Types of Mortgages

In the 1980s, long before I joined the mortgage sector, interest-only mortgages were often subject to higher interest rates than repayment deals, with the repayment vehicle usually being an endowment policy.

Some 30 years later this interest differential is again being enforced by lenders, leaving repayment mortgages with cheaper rates. Cynics may argue that this is to curb the advance of interest-only.

And the future of interest-only is indeed a big debating point. There are widely differing views on the subject and, depending on individual circumstances, who is to determine which is right or wrong?

Why should either lenders or regulators be able to dictate which is the permitted route for borrowers when everyone’s circumstances are different?

All too often, interest-only mortgages have been sold based on ease rather than circumstances. Any sane adviser should ensure that clients have the means to repay the capital debt on or before their retirement date.

But how does this fit with a client who is looking forward to a large lump sum payment on retirement and wishes to enjoy lower outgoings in the meantime? Or one who receives annual bonuses and prefers to have an offset-type interest-only mortgage, using their bonus lump sum to pay into their mortgage when they get it?

And what about those who have been hit hardest in recent times - the self-employed? Many lenders shut the door on this group of borrowers yet they are often the ones who rely most on the flexibility of interest-only to tie in with fluctuations in their incomes. After all, those who manage business budgeting are likely to be the most astute when it comes to managing their own finances and plans for repaying their mortgage.

Repayment mortgages provide the certainty of clearing debt at the end of the term for both lenders and consumers, while lenders are trying to avoid risky lending. And although the Financial Services Authority has demanded tighter controls on interest-only in its Mortgage Market Review, there is a need for it to think outside the box.

The financial impact on first-time buyers in terms of set-up costs and monthly outlay when they purchase a property should be taken into account. For larger loans, the risk involved with interest-only appears to be greater, yet often this type of borrower will be a higher earner with the ability to make capital reductions.

That said, we need a sensible approach to this argument and a rational agreement as to who does or does not suit the profile. There’s no right or wrong answer when it comes to interest-only and the consequences of any proposals need to be evaluated over a period of time rather than dashing into a knee-jerk reaction.

 

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