More Mortgage Info                                                       CML Housing Finance Issue 11 2006




           ...
More Mortgage Info
CML Housing Finance



                      scheduled repayments of the capital until the end of the l...
More Mortgage Info                                                                     Interest-only: why all the interest...
More Mortgage Info
CML Housing Finance



                      Chart 2: Methods of repayment, Q3 2006

                  ...
More Mortgage Info                                                                     Interest-only: why all the interest...
More Mortgage Info
CML Housing Finance



                      expensive properties, but because of their higher incomes ...
More Mortgage Info                                                               Interest-only: why all the interest?



 ...
More Mortgage Info
CML Housing Finance



                      later date to repay the debt. This would of course be a po...
More Mortgage Info                                                                 Interest-only: why all the interest?


...
More Mortgage Info
CML Housing Finance



                      Chart 8: “Self-certified” loans by method of repayment, em...
More Mortgage Info                                                       Interest-only: why all the interest?



         ...
More Mortgage Info
CML Housing Finance




                             Further information on Housing Finance
           ...
Upcoming SlideShare
Loading in …5
×

Interest Only Why all the interest

643 views

Published on

Interest Only Why all the interest

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
643
On SlideShare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
7
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Interest Only Why all the interest

  1. 1. More Mortgage Info CML Housing Finance Issue 11 2006 Interest-only: why all the interest? About a quarter of new regulated mortgages are taken out on an interest-only basis where there is no known repayment vehicle. Although this proportion has remained stable for at least 18 months, the FSA has recently expressed concern that such large volumes appear to have no formal plans for ultimate capital repayment. We have found no evidence for the widely-held assertion that affordability pressures are driving borrowers to interest-only products. First-time buyers are in fact less likely to take out straight interest-only loans than other borrowers. Income multiples are similar or slightly lower than for capital and interest borrowers. Data suggests that the typical borrower taking out a straight interest-only mortgage has a similar ability to repay as a capital and interest borrower. Many borrowers opting for interest-only products appear to be cash-flow constrained. This may be because their income is "lumpy" and they value the ability to combine minimum monthly outgoings with the freedom to make lump-sum repayments of capital as and when their income allows. Or because of personal circumstances, such as a recent history of credit problems. Risk factors, such as high LTVs, borrowers with an impaired credit history and self- certified, are associated with straight interest-only borrowing to varying extents, but these are mitigated at least in part by lower risk in other areas. Unfortunately, we know too little about the motivation of borrowers who take out interest- only mortgages, or their actions after the mortgage sale, to form more concrete views at this stage. The FSA has been conducting research in this area and will be publishing its findings in December 2006. Introduction When taking out a mortgage, each borrower makes a choice on how to repay the capital on the loan. There are many options, but they can be broken down into two main types – capital and interest, or interest-only. With capital and interest, the borrower repays the loan principal in Author increments over the life of the loan. This is a risk-averse option, giving the borrower certainty James Tatch that the loan will be repaid as long as they make their contractual payments throughout the term Senior Statistician, CML of the mortgage. Editor Bob Pannell The other option is an interest-only mortgage. Here the contract between the lender and Head of Research, CML borrower relates only to paying interest on the loan throughout the life of the mortgage, with no November 2006 1
  2. 2. More Mortgage Info CML Housing Finance scheduled repayments of the capital until the end of the loan. So the balance outstanding remains the same unless the borrower makes discretionary capital repayments. Interest-only borrowers may choose whether or not to take out an investment vehicle to sit alongside the mortgage. For those borrowers who choose not to, they can always make discretionary repayments later on. However the longer they leave it, the larger any regular payments would have to be because there is less time left to pay the principal off. If no arrangements are made there is risk that, when the principal becomes due for repayment at the end of the mortgage term, they may have no specific means of doing so. It is unclear to what extent this is happening in the market, but the FSA is currently conducting research to assess whether some areas of interest-only borrowing is problematic. This article focuses on "straight" interest-only loans, where there is no known repayment vehicle. Market data on interest-only There are some substantial questions around the data on interest-only mortgages. The information is difficult to collect and monitor, because often the mortgage lender is not the provider of the investment vehicle, if one exists. Borrowers are under no obligation to tell their lender what investment vehicle they have chosen, and the FSA does not require lenders to monitor this information (we discuss the regulatory issues later in more detail). In addition, lenders are not able to monitor whether payments into the investment are kept up throughout the term of the mortgage, or how any investment is performing. Figures from the Survey of Mortgage Lenders (SML) give an historical perspective on trends in methods of repayment. In the 1970s the majority of loans were taken out on a capital and interest basis. But the 1980s saw a switch to interest-only, mostly backed with endowment policies. Since the mid 1990s there has been a dramatic switch back to capital and interest, due in large part to the poor performance of endowment policies, associated with significant changes in the interest rate environment. The proportion of interest-only mortgages where there was no known repayment vehicle climbed during the late 1990s to peak in 1999, at just below a quarter of new mortgages. This proportion then dipped temporarily before reviving again from 2003 onwards. The SML was discontinued in 2005 and replaced with the CML's more comprehensive Regulated Mortgage Survey (RMS). One of the unfortunate consequences of this change, reflecting substantial differences in SML and RMS methodologies and survey coverage, is that information on repayment methods cannot be readily compared across the two sources. The RMS collects data from lenders on individual regulated mortgage transactions - predominantly house purchase loans and remortgages. Amongst other data items, RMS collects data on the method of repayment, broken down by capital and interest, interest-only with 2 November 2006
  3. 3. More Mortgage Info Interest-only: why all the interest? specified vehicle (endowment, ISA, pension and other). But it also has a category for interest- only with unknown vehicle. For this last category, there may in fact be a vehicle in place, but if the lender does not have the means to identify it (for example because it is provided by another firm), then they can only report that the loan is on an interest-only basis with no evidence of an investment vehicle being in place. This provides an upper limit on how many regulated loans there may be on a straight interest-only basis. RMS indicates that in the third quarter of 2006 around 23% of reported loans were taken out on an interest-only basis where the lender could not verify what investment vehicle, if any, the borrower had in place. This proportion has remained stable since the RMS began in April 2005. Chart 1: Methods of repayment, house purchase loans % 100 80 60 40 20 0 1975 1980 1985 1990 1995 2000 2005 Capital and interest Interest-only with repayment vehicle Interest-only with no known vehicle Mix of repayment types Source: Regulated Mortgage Survey/Survey of Mortgage Lenders, CML/BankSearch and DCLG Notes: From April 2005 onwards, there is a major shift in the reported incidence of interest-only loans as a result of the switch in data source from the SML to the RMS. Who takes out interest-only loans? RMS figures indicate that 17% of first-time buyers take out a mortgage on an interest-only basis with no known repayment vehicle. This compares with around 25% for home movers and those remortgaging. Although first-time buyers are less likely to choose interest-only than other borrowers, we might expect those who do to be more vulnerable because they face the most severe affordability constraints and have the least equity. For this reason, our analysis focuses mostly on first-time buyers. Broadly speaking, however, the identified trends apply equally to other types of interest-only borrower. November 2006 3
  4. 4. More Mortgage Info CML Housing Finance Chart 2: Methods of repayment, Q3 2006 % 80 70 60 50 40 30 20 10 0 Capital and interest Interest-only with Interest-only with no Mix of repayment repayment vehicle known vehicle methods First-time buyers Home movers Remortgagors Source: Regulated Mortgage Survey, CML/BankSearch We know that first time buyers are more likely to use mortgage intermediaries than other borrowers. They are new to the housing market and so may be less comfortable with shopping around and prefer to use the services of a broker. The RMS tells us that a higher proportion of intermediary business comprises interest-only mortgages sold with an accompanying investment vehicle alongside. But the RMS data also shows that 21% of first-time buyers who buy via an intermediary take out an interest-only product where there is no known repayment vehicle. This compares with just 10% of those who buy direct through the lender. But this does need to be interpreted with caution. If a borrower goes through a broker for an interest-only loan and also takes out a repayment vehicle, they will most likely buy this through the broker too. And because the lender did not provide the vehicle, they are less likely to know of its existence. Chart 3: Repayment methods by distribution channel, first time buyers Q3 2006 % 80 60 40 20 0 Capital and interest Interest-only with Interest-only with no Mix of repayment repayment vehicle known vehicle methods Direct Via intermediary Source: Regulated Mortgage Survey, CML/BankSearch 4 November 2006
  5. 5. More Mortgage Info Interest-only: why all the interest? The added difficulty in identifying the repayment vehicle for loans sold via intermediaries could potentially distort other findings. For this reason we have undertaken each of the following analyses separately for direct and intermediary sales. In each case, the findings remain valid and so we have not shown the results separately. Interest-only for income-stretch? At a time of intense affordability pressures, one possible reason for taking out an interest-only loan without a formal repayment vehicle could be to reduce the burden of monthly mortgage payments. A homebuyer taking out an average size loan of £120,449 in Q3 2006, at a typical interest rate of 5.01% over 25 years, would face a monthly capital and interest payment of £713. But on an interest-only basis with no repayment vehicle, the total payments would be £515. Borrowers desperate to get onto (or move up) the housing ladder might choose interest-only as the only way of servicing a mortgage large enough to enable them to purchase their chosen property. While we have already seen that first-time buyers are in fact less likely than other borrowers to choose interest-only (Chart 2), we need to look at whether those first-time buyers who do choose interest-only are particularly stretched. The RMS data shows clear differences between the affordability characteristics of first-time buyers taking out interest-only mortgages with no known repayment vehicle and those on capital and interest. Table 1: Affordability characteristics, first-time buyers, Q3 2006 Repayment method . Capital Interest-only and with no known interest Repayment Vehicle Loan size £102,000 £133,551 Purchase price £125,000 £155,000 Deposit £11,609 £14,000 Income £32,070 £42,500 Percent advance 90 90 Income multiple 3.22 3.18 Debt servicing ratio, % 16.7 17.6 Source: Regulated Mortgage Survey, CML/BankSearch Notes: Figures shown are based on medians of affordability statistics for individual loans, and so will not cross-calculate within the table. This does in fact provide a further degree of comfort. Interest-only borrowers have substantially higher incomes than those on capital and interest. They take out larger loans to buy more November 2006 5
  6. 6. More Mortgage Info CML Housing Finance expensive properties, but because of their higher incomes they have broadly similar income multiples to those on capital and interest. This provides further evidence that first-time buyers are not systematically using interest-only for income stretch. Instead it suggests a preference by more affluent borrowers to choose their own repayment strategy to accompany an interest-only mortgage. A similar pattern is found across every region of the UK and for all types of borrower, with interest-only borrowers having higher incomes and the same or lower income multiples than those on capital and interest. Interest-only lending on the fringes? In the first-time buyer market, there will always be some at the high end of the affordability spectrum who seek to borrow at the limits and maximise their borrowing capability. This is especially so in the current climate, with the ratio of house prices to incomes significantly in excess of the long-run average. But are those borrowing near the limits gravitating to interest- only? Although the typical income multiples of first time buyers on capital and interest and interest- only are similar, there are small differences in the distribution of loans around this. A similar proportion of interest-only and capital and interest borrowers take out loans below three times income multiple. A higher proportion of interest-only loans are taken out at three to three and a half times income multiple compared to those on capital and interest. But the converse is true at higher income multiples – especially above four times income - where lenders rely more heavily on affordability models and/or manual underwriting processes to assess risk more fully. This appears to be strong evidence that the most affordability-stretched of borrowers do not go for straight interest-only. Chart 4: Distribution of income multiples, first time buyers Q3 2006 % 35 30 25 20 15 10 5 0 under 2 2.0<3.0 3.0<3.5 3.5<4.0 4.0 and over Capital and interest Interest-only with no known vehicle Source: Regulated Mortgage Survey, CML/BankSearch 6 November 2006
  7. 7. More Mortgage Info Interest-only: why all the interest? Looking at the distribution of loan-to-valuation ratios, a different picture emerges. The data indicates that the typical first-time buyer takes out a loan with a 90% LTV, whether on capital and interest or interest-only. But a significantly higher proportion of borrowers on interest-only have LTVs between 90% and 100% (and significantly fewer with LTVs under 70%). So those on interest-only are more likely to have a smaller equity cushion at the outset of the loan, putting them at greater risk if their circumstances take an early turn for the worse. Chart 5: Repayment methods by loan-to-valuation band, first time buyers Q3 2006 % 30 25 20 15 10 5 0 < 50% 50%<70% 70%<80% 80%<90% 90%<95% 95%<100% 100% and above Capital and interest Interest-only with no known vehicle Source: Regulated Mortgage Survey, CML/BankSearch Of course, lenders look at LTV and income multiple in conjunction when assessing each loan application. As one would expect, higher LTVs tend to be offset by lower income multiples and vice versa., and this is equally true for interest-only mortgages. In fact, the combination of higher income multiple and higher LTV appears slightly more favourable than for those taking out capital and interest products. We know from Table 1 that borrowers who take out a straight interest-only mortgage are typically able to afford capital repayments. An interesting question then is what they are doing with the money they are not spending on a repayment vehicle. Some borrowers may in fact opt for straight interest-only so they can pay off the loan in lump sums as and when they choose. This may be an attractive option for individuals, such as contract workers, the self-employed or employees expecting substantial bonuses, who have incomes that are "lumpy". A straight interest-only product gives such borrowers the flexibility to pay off their principal on an ad-hoc basis, while at the same time minimising their regular monthly outgoings. Unfortunately, we don't know the extent to which borrowers are in fact doing this, because we do not know what borrowers do after the point of sale. There may well be some borrowers who take out interest- only loans at relatively high LTVs, and who are counting on selling the property at a profit at a November 2006 7
  8. 8. More Mortgage Info CML Housing Finance later date to repay the debt. This would of course be a potential high risk strategy for getting onto the housing ladder, because it presumes that the housing market continues to be buoyant. Another area of higher risk lending is the adverse credit market. Here the data indicates that borrowers with an impaired credit history are significantly more likely to choose interest-only than prime borrowers. This is understandable, given that many such borrowers are likely to be cash-constrained and facing a challenging few years in getting their finances back onto an orderly basis (see Housing Finance article on adverse credit mortgages). Chart 6: Proportion of loans that are interest only by credit history of borrower, Q3 2006 % 40 35 30 25 20 15 10 5 0 First-time buyers Home movers Remortgagors No adverse credit Adverse credit Source: Regulated Mortgage Survey, CML/BankSearch Notes: Adverse credit history conforms to the definitions set out by FSA for mortgage reporting, and relates to material loan arrears, CCJs and recent IVAs or bankruptcies. Table 2: Affordability characteristics, first-time buyers on interest-only by credit history, Q3 2006 Credit history of borrowers No adverse Adverse credit history credit history Loan size £135,000 £118,800 Purchase price £157,500 £125,000 Deposit £14,400 £9,537 Income £42,700 £40,000 Percent advance 90 90 Income multiple 3.20 2.96 Debt servicing ratio 17.5 18.3 Source: Regulated Mortgage Survey, CML/BankSearch Notes: 1. Figures are medians of affordability statistics for individual loans, and so will not cross-calculate within the table. 2. Adverse credit history conforms to the definitions set out by FSA for mortgage reporting, and relates to material loan arrears, CCJs and recent IVAs or bankruptcies. 8 November 2006
  9. 9. More Mortgage Info Interest-only: why all the interest? When we look further at the profile of interest-only borrowers (Table 2), we see that those with adverse credit history have broadly similar incomes to those without, but borrow substantially less. This means that they have a significantly lower income multiple – at a shade under three times income this is well below the industry average for all first-time buyers. So, although credit-impaired borrowers are more likely than others to choose interest-only, they are not simultaneously stretching their income excessively. This suggests that the straight interest-only nature of many impaired credit loans does not represent a material additional risk factor. One factor that can mitigate borrowers' risk is the type of interest-rate product chosen. Fixed rate loans insure highly-leveraged borrowers against payment shocks if short-term interest rates rise. However the data indicates that interest-only borrowers are more likely to choose discounted variable and tracker rate products, and so do not seem to be mitigating risk in this manner. This suggests that there may be a greater overall degree of interest rate risk associated with such lending. But it is difficult to quantify this because we do not know what straight interest-only borrowers do with the money not allocated to capital repayments or a repayment vehicle, and how this may affect their coping strategy if short-term interest rates rise. Putting such money on short-term deposit could for example provide a significant cushion in such circumstances. Chart 7: Interest-only lending by type of interest rate product, first- time buyers Q3 2006 % 90 80 70 60 50 40 30 20 10 0 Fixed rate Discounted Tracker Capped SVR Other variable rate Capital and interest Interest-only with no known vehicle Source: Regulated Mortgage Survey, CML/BankSearch A separate area of regulatory interest is self-certified lending – where the lender does not require the borrower to provide proof of income. The RMS does not explicitly identify self-certified loans, and there is a significant grey area in reporting as to where "fast track" lending ends and self cert begins. But we are able to undertake a "broad brush" analysis making use of the fact that lenders do relatively little fast track lending over 75% LTV. We focus here on those borrowers who are employed. November 2006 9
  10. 10. More Mortgage Info CML Housing Finance Chart 8: “Self-certified” loans by method of repayment, employed borrowers only Q3 2006 % self-certified 16 14 12 10 8 6 4 2 0 First-time buyers Home movers Remortgagors Capital and interest Interest-only with no known vehicle Source: Regulated Mortgage Survey, CML/BankSearch Notes: The measure of self-certified lending is a CML defined proxy measure only and the proportions shown are intended to indicate orders of magnitude only. As we can see from Chart 8, employed interest-only borrowers are more likely to choose a self- certified loan than borrowers on capital and interest, but the overall percentage differences are small. While there could be isolated instances of self cert borrowers inflating their incomes fraudulently, so obtaining a larger and riskier loan, lenders go to considerable lengths to ensure that this does not happen and the FSA has not identified any systematic problems to date. The reported incomes of self-certified borrowers are somewhat higher than others, but firms typically apply more conservative lending criteria including lower income multiples, so the overall impact on credit risk is likely to be fairly neutral. What the regulator says Borrowers who take out loans on an interest-only basis are under no contractual obligation to put a repayment vehicle in place. The FSA does not expect lenders to require or verify that the borrower puts adequate arrangements in place. As described earlier, it would be problematic to do so since a borrower is free to purchase an investment vehicle from anybody they choose. The FSA does, however, require lenders under Mortgage Conduct of Business (MCOB) rules to clearly point out to borrowers on interest-only mortgages what the implications of this repayment choice are. Specifically each annual statement reminds the interest-only borrower that at the end of the term the full amount of the original advance will become due. The statement goes on to make it clear out that the borrower must ensure they have the means to repay the principal at the end of the term. A further provision is made for interest-only lending under the Responsible Lending section of MCOB. Specifically, if the lender knows that all or part of a loan is to be on an interest-only basis, they should assess affordability as if the borrower were on capital and interest. We have 10 November 2006
  11. 11. More Mortgage Info Interest-only: why all the interest? seen that interest-only borrowers typically have the same or slightly lower income multiples than those on capital and interest. This provides strong evidence that lenders are indeed assessing affordability in accordance with MCOB rules, regardless of the borrower's chosen method of repayment. And in providing them with clear advice on the risks and implications of interest- only borrowing, both at the outset and in each year's annual statement, the lender will have made sure the borrower has both the financial wherewithal and information to make adequate arrangements for repayment of the loan. Although interest-only is well provided for under MCOB rules, it nonetheless remains a closely watched area, especially for those borrowers thought to be most at risk. The FSA is currently conducting thematic research into interest-only mortgages, focusing on Treating Customers Fairly issues – including ensuring that interest-only borrowers have been given suitable advice at the point of sale and throughout the life of the mortgage. The research findings are due out in December 2006. Conclusions In examining the profile of borrowers taking out straight interest-only mortgages compared with other borrowers, there does not seem to be a systemic pattern that puts them in a materially different risk category. They do tend to have higher LTVs, but they also have higher incomes and broadly similar income multiples compared to other borrowers. A higher proportion of interest-only borrowers come from the credit-impaired and self-certified sectors, but in these cases there are also mitigating factors that fully or partially offset these risks. We look forward to the light that the FSA's research will shed on this area of mortgage lending when it is published in December 2006. References Financial Services Authority (2003), Mortgages: Conduct of Business Sourcebook Instrument, Financial Services Authority Pannell, B and Smith, J (2005) Understanding first-time buyers, CML Research Pannell B (2006), Adverse credit mortgages, CML Research Tatch, J (2006) Will the real first-time buyers please stand up?, CML Research November 2006 11
  12. 12. More Mortgage Info CML Housing Finance Further information on Housing Finance Housing Finance is an authoritative online journal which provides in-depth articles on a wide range of mortgage related issues. For free online access to other recent articles and a subject index see http://www.cml.org.uk/cml/publications/research. A package of CML Statistics that complement Housing Finance online is free to members and associates or can be subscribed to by non-members (for details see http://www.cml.org.uk/cml/statistics/statssub). For further information on Housing Finance articles contact the editor Bob Pannell at bob.pannell@cml.org.uk. © Copyright 2006 Council of Mortgage Lenders. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic or mechanical. Photocopying or other means of recording are forbidden without the prior written permission of the publisher. The Council of Mortgage Lenders 3 Savile Row, London, W1S 3PB Telephone: 020 7437 0075 Fax: 020 7734 6416 Every effort has been made to ensure the accuracy of information contained within the report but the Council of Mortgage Lenders cannot be held responsible for any remaining inaccuracies. The opinions expressed in this report are the responsibility of the authors alone and are not necessarily the views of the Council of Mortgage Lenders. ISSN: 0955-3800 12 November 2006

×