Back in the heyday of have-it-all mortgages – those 125% deals to people with poor credit histories we now all remember so well as the beginning of the financial crisis, interest-only mortgages were super popular.
Interest-only, for the uninitiated, means you repay only the interest on the mortgage you have taken out, leaving the capital – the actual amount of the loan, unpaid. The idea is that you put the money that you would have used to repay the capital into some higher-earning investment that accrues sufficient value to be able to meet the bill for the capital at the end of the mortgage term.
Clearly, the danger here is that there isn’t enough in the pot to cover the capital at the end of the term.
The Council of Mortgage Lenders puts out frequent notes on the status of historic interest-only loans because it understands the anxiety among its own member lenders, policymakers and all stakeholders in the housing market that many of the loans that were offered on an interest-only basis during the heady lending days are in danger of failing to be repaid.
The industry body figures show that homeowners with these loans are in fact paying off the balance at the end of the term. The latest note said: “The number of interest-only loans continues to decline, and has now fallen by 40% in the five years we’ve been collecting data. Encouragingly, some of the biggest falls are in the number of interest-only mortgages at higher loan-to-value. And even when a mortgage is not repaid immediately on the due date, in the majority of cases it is redeemed in full shortly afterwards by the borrower.”
The market for interest-only has been shrinking because lenders pulled the drawbridge up to all but the highest earners, stating minimum income requirements of £150,000 to be considered for a new interest-only loan, on the basis that people earning this much have a fair chance of putting enough away into investments to pay off the balance at the end. Lenders did this because they were (and still are) nervous about losses on existing stock and uncertain about the future of house prices. They also suffer from a transparency problem – once a mortgage has been granted, then as long as a borrower is repaying what they owe, the lender has no opportunity for insight into their circumstances and what they are doing with that extra cash.
Around 1.9 million homes, or one fifth of the mortgaged housing stock, is on an interest-only deal. Many of these were agreed at a time when lenders were far less stringent.
What’s worrying is that many borrowers who took advantage of interest-only a few years back and never returned to repaying the capital may have adjusted to their lower outgoings, reducing their income or increasing their spending accordingly, rather than putting some aside into investments. There is no way of knowing how many homeowners are in this position.
The CML may feel assuaged by the data but without full visibility over the finances of those with these loans, the risk level still looks high. Anecdotally, there remains a lazy assumption among some (my own peer group included) that their house price will rise by enough to cover anything outstanding at the end of the term.
This is the type of wishful thinking that makes me feel a bit nauseous, actually. Because if that didn’t happen… well, the bill is not the kind you can meet through ultra-tight budgeting for a few months.
I’m not a mortgage broker or financial adviser, but speaking personally, I can’t see any reason not to repay capital on a home loan. You are usually going to be better off in the long run if you just clear debts as quickly as humanly possible.
Now, some ultra savvy borrowers would think that is foolhardy of me, when borrowing rates are so low and returns on other investments can be pretty high. They are right – it is possible to engineer your borrowing and investing so that you repay the minimum on loans but have made more than enough to cover any outstanding balance through high-earning investments by the end of the term.
But you have to be pretty confident that you know what you are doing. The reality, unfortunately, for many interest-only borrowers who snuck in there is that they need to be on those lower repayments – often hundreds of pounds a month cheaper – just to get by.
And that’s where the rot could still set in. Particularly now that lenders are freeing up interest only loans to more borrowers again. Santander, HSBC and Bank of Ireland now all offer interest-only loans to new borrowers – although the criteria are still tough, they are relaxing. Natwest has reduced its minimum income requirement from £100,000 to £75,000 for at least one of the applicants. Santander has totally removed its minimum income requirement.
Aaron Strutt, product director at Trinity Financial, says: “If you are looking for an interest-only mortgage there is a wide selection of lenders to choose from, although some of the lenders have tougher criteria than others.
“Santander has relaxed its interest-only policy by removing its minimum income requirement, and it raising the maximum age from 65 to 70. If the sale of the property is being used as a repayment vehicle, there needs to be a minimum of £150,000 amount of equity at the end of the mortgage term.”
Don’t get me wrong – it’s a useful trick if you are confident and know what you are doing. But if you are switching to interest-only out of desperation or simply because you fancy going on a nicer holiday every year, you could be taking a risk that personally speaking, makes me dizzy.
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