What is an interest-only mortgage?
Interest-only mortgages are home loans on which borrowers pay only the interest due on their debt, rather than paying down the capital too. As a result, interest-only mortgages are – initially – cheaper to service than repayment mortgages, with lower monthly payments due.
How do they work?
Borrowers pay only the interest on their debt, rather than paying down the capital too. However, this means that when the mortgage term comes to an end, the initial loan remains to be paid off.
For example, a borrower takes out a £100,000 loan over a 25-year term, with an interest rate of three per cent (we will assume it’s fixed for life for simplicity).
On an interest-only basis, the borrower pays £250 per month for 25 years (£75,000 in total) then owes the capital £100,000 at the end of the 25-year term – total £175,000 paid
On an capital and interest basis the borrower pays £474 per month for 25 years (£142,000 in total) then owes nothing – total £142,000 paid
Borrowers taking out interest-only mortgages are expected to have put plans in place to enable them to repay the loan, for example, a savings plan or other investments.
How many people have interest-only mortgages?
In 2012 there were some 3.2 million interest-only loans outstanding. This included both interest only and part-and-part mortgages (a combination of both interest only and repayment) and was equivalent to a third of all homeowner mortgages.
Today, following work by the industry and lenders to help borrowers and reduce the size of the interest-only book, our figures show there are now 1.7 million interest-only mortgages outstanding.
Why did the Financial Conduct Authority carry out a review into interest-only mortgages?
The FCA carried out a review in 2013 to assess whether interest-only mortgages were working for customers and whether borrowers would be able to repay their debt as the interest-only loan reached maturity. It identified three distinct tranches of interest only maturities, 2012 – 2020, 2021 – 2027 and 2028 – 2033. They also encouraged lenders to step up their engagement in terms of communicating with customers well before they come to the end of their IO loan. In 2015 lenders fulfilled an industry-wide commitment to contact all interest-only borrowers with loans scheduled to mature before the end of 2020, to ensure they were on track to repay their loans and, where there looked to be problems, work with borrowers to rectify the situation.
What does this mean for borrowers with an interest only mortgage?
While making contact with borrowers who are more reluctant to engage remains a challenge, there is also evidence that lenders are seeing greater success here, and the vast majority of borrowers who do engage have repayment plans in place. However, there is a small minority of borrowers each year that do not redeem their interest-only mortgages in full on the maturity date. Last year there were 34,000 such ‘term-expired’ mortgages.
What happens in cases like this?
The majority – about 90 per cent – of such cases do actually redeem their mortgage in full shortly (within three months) after the maturity date has been reached, without the need for any intervention.
Where this does not happen, lenders will typically offer borrowers a range of options to allow repayment of the loan. This might involve formally extending the term of the loan. Alternatively, growing numbers of borrowers are moved instead on to repayment mortgages and repay the loan in that way. A number of borrowers sell their properties to repay the mortgage debt.
Last year, there were 250,000 mortgages which moved out of the interest-only mortgage book. Of these 21,000 (eight per cent) were conversions to capital and interest with the same lender, and almost all the rest were full redemptions.
What about interest-only mortgages today?
The FCA tightened the rules on interest-only deals in 2014 following the Mortgage Market Review, so that lenders have to be comfortable that 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 previously.
What about interest-only mortgages on buy-to-let properties?
Interest-only mortgages are the most popular option in the buy-to-let world, with the majority of landlords opting to take out these deals rather than repayment mortgages. One main advantage is that such mortgages are less expensive than repayment mortgages in the short term. Landlords can use the rental income from the tenant to cover the interest payments on the mortgage. The rates on buy-to-let mortgage deals are also typically higher than on residential mortgages, so this can be a way to counter the increased costs.
But this sounds risky, is it?
While interest-only buy-to-let mortgages may sound risky because the landlord is not paying off the capital debt, those buying property as a business typically have a different perspective to those buying their own home to live in. Most landlords will view buy-to-let as a long-term investment. They will be counting on an appreciation in house prices which they hope will, in time, allow them to sell the property, pay off the mortgage debt and still make a profit.
There is a risk that if house prices fall landlords will find themselves in negative equity and be unable to remortgage or even sell the property. While these must be considered the majority of landlords will be taking a long-term perspective and be prepared for ups and downs in the housing market. Lenders build in an element of times when the property may not have tenants to help make sure the loan remains affordable for the landlord.
How is UK Finance involved?
Last year the FCA carried out follow-up work to its 2013 thematic review into interest-only mortgages and found very few problems with lenders’ treatment of borrowers with interest-only mortgages. However, it did highlight the reluctance of some borrowers to engage with lenders, and urged those borrowers facing difficulty in repaying their mortgage to talk to their lender and discuss their options. At UK Finance we welcome and echo this message. We are reviewing our interest-only toolkit, which provides good practice guidance to lenders, and we will continue to look at ways we can innovate, learn and grow to the benefit of lenders and customers, in an ever-changing regulatory landscape.