Handle interest-only deals with great care

I wrote recently about the slowdown in the US sub-prime market. In the past few weeks the situation has worsened considerably.

Lenders across the industry have tightened lending criteria, Freddie Mac has stopped buying some types of sub-prime loans and the regulators are threatening to step in.

It is generally acc-epted that the problems have been caused by US lenders that relaxed criteria to sustain volumes in an increasingly competitive but slowing market.

The good news is that the closer you look at the fundamental causes behind American slowdown, the more different it seems to the UK situation.

The housing market in the US overheated and the loans advanced by some sub-prime lenders were astonishingly bold. For example, self-cert interest-only loans up to 100% LTV were considered normal.

Some loans of this type also had low initial teaser rates with several subsequent step-ups over the life of the loans.

I’m pretty confident that the UK market is a little more responsible than this, particularly given the still-recent introduction of Financial Services Authority regulation.

Also, house price growth over here seems to be relatively stable and the lack of available homes is a major national difference from the substantial oversupply of housing in the US.

But there are some aspects of the US sub-prime slowdown that warrant further scrutiny – interest-only lending in particular.

Consider this – in a rising house price environment with stable wages, employment and interest rates, borrowers can remortgage repeatedly to achieve the best rate.

Lenders will be confident that even if borrowers default, rising house prices will protect them. This scenario describes the past two or three years of lending in the UK.

Now look at the situation today. Interest rates have risen, not significantly but enough to put a strain on many borrowers as evidenced by rising arrears and repossessions.

House price growth has slowed and the smart money is on a further gradual slowdown as the impact of base rate rises continues to work through the system,.

So rates are rising and arrears and defaults are rising. The only thing stopping lenders tightening their controls is continued house price appreciation. If this slows further or stops, losses will rise. At this point, lenders will belatedly tighten their lending limits.

Borrowers paying capital and interest will be affected but at least they will have been growing the equity in their homes over time and therefore have some options to remortgage onto competitive rates as their LTVs will be lower.

On the other hand, interest-only borrowers – particularly those on high LTVs to start with – will be in trouble.

The inherent risk in their positions will prevent remortgaging with more risk-averse lenders and they will be stuck on high reversion rates.

Already under pressure, they will struggle to pay rising interest whilst failing to amass equity.

Admittedly, this is worst case scenario stuff but still, interest-only loans should be handled with great care.