Warning as lenders move to cut back interest-only mortgages

Published on Tuesday 26 April 2011 16:10

Homeowners on interest-only mortgages have been advised to bolster their repayment plans after lenders moved again to reduce their exposure to the market.

The demise of interest-only mortgages has moved a step closer in recent weeks as some of the UK's biggest mortgage providers further restricted access to the loans, spelling bad news for the many buyers.

Experts warn that hard times lie ahead for homeowners already on interest-only mortgages, thanks to a combination of falling house prices and a potential interest-rate hike

The loans, originally designed for buy-to-let investors, found huge popularity among first-time buyers during the housing boom as they allowed borrowers to pay only the interest on the mortgage and clear the capital later in the term. With house prices soaring in the mid-noughties many assumed the sale of their property would be sufficient to pay off the capital. The market slowdown poses a serious threat to such plans.

Big changes to the market were signalled last year by the Financial Services Authority (FSA), which said it would consider banning the loans. It has since stepped back from that, but proposals requiring lenders to monitor the ability of borrowers to find a suitable repayment plan have sparked a rapid move away from the market.

Many lenders have stopped offering interest-only deals for first-time buyers, including Royal Bank of Scotland, while others have tightened their lending criteria considerably.

Earlier this month Lloyds Banking Group doubled the minimum amount it will lend borrowers taking out interest-only mortgages through its branch network to 1 million. The change, being extended across its intermediary brands over the next few weeks, came after the lender hiked the cost of its interest-only loans, reduced the range of repayment vehicles it accepts and introduced a requirement to provide documentary evidence of repayment plans.

Lloyds is also among several lenders to have reduced the maximum size of interest-only mortgages to 75 per cent loan-to-value (LTV), with Nationwide making a similar move.

Lenders still offering interest-only mortgages of 85 per cent LTV or larger are now in a minority, with the big names all pulling back.

A spokeswoman for Lloyds said: "The initiatives have resulted in improved controls relating to this sector; they include a defined list of acceptable repayment vehicles and a process whereby borrowers provide evidence of a repayment vehicle both at application and throughout the life of the mortgage."

Of the lenders still offering interest-only loans, most say that property sale proceeds or inheritance windfalls are no longer acceptable as a repayment plan.

If the restrictions threaten the very existence of interest-only mortgages, however, borrowers will lose a vital loan option, argued Melanie Bien, director of independent mortgage broker Private Finance.

She said: "If interest-only mortgages completely disappear, or become so limited in scope that they are available only to a handful of borrowers, there will inevitably be less choice for consumers.

"Yet interest-only loans aren't inherently bad. For the first-time buyer on a limited income, an interest-only loan might be their only way of getting on the housing ladder."

First-time buyers who don't have a repayment vehicle but are due to come into an inheritance that would easily clear the capital should not be excluded from interest-only mortgages, nor should people on low incomes now but expected to earn significantly more later in their career, claimed Bien.

"Take barristers, for example, earning fairly modest incomes initially but likely to earn a lot more as their career progresses," said Bien. "Would you deny them a mortgage until they were in that position?"

Interest-only loans are also popular among some high earners who plan to use their bonuses to clear the capital, Bien noted.

"This is why the private banks are often a good source of interest-only mortgages as they haven't tightened their lending because they understand this area of the market so well. Lloyds has also recognised this, increasing the maximum interest-only loan from 500,000 to 1m," she said. "However, borrowers will still need to provide evidence of a repayment strategy for paying back the capital at the end of the term, so it is still responsible lending."

The diminishing interest-only mortgage market poses a particular problem for those who took out high LTV mortgages during the boom years and had no capital repayment plan other than the sale of their property.With house prices sinking over the last three years and little sign of a sustained improvement any time soon, those borrowers - and their lenders - are becoming anxious about their capital repayment prospects.

Experts advise homeowners on existing interest-only mortgages to look closely at their repayment plans, with lenders increasingly likely to scrutinise them when it comes to remortgaging.

The dramatic tightening in lender criteria and affordability checks means that being able to demonstrate a robust repayment plan will now have a significant impact on the amount you can borrow when remortgaging. The sale of the property, on which many people are depending to clear their capital, is unlikely to be satisfactory.

Harry McGeough, director of Mortgageforce in Glasgow, said: "While there may be little to worry about under the present mortgage agreement, provided you are making your monthly repayments should you decide to move you are going to need at least a 25 per cent deposit if you want another interest-only deal.

"This is a real change to their ability to secure a mortgage second time round even if they have paid on time."

He recommended building up monthly savings and transferring bonuses to a regular savings account such as an Isa.

"If you put down a smaller deposit you will face capital and interest repayments per month which are obviously substantially more, and the total amount borrowed may be less than before - another significant change for the borrower."