Interest Only Why all the interest

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
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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
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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.
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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
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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
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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
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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
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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.
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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.
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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
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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
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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.
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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