The very mention of interest only will draw differing responses, depending on who you are talking to. Prima facie it looks like interest only has a public relations problem in some quarters. However, the subject does deserve a thorough examination, especially as sales of interest only mortgages appears to be increasing.
The signs of increasing popularity have attracted the attentions of the Financial Services Authority (FSA). Interest only is seen as a possible issue and as such is firmly on the regulator’s radar. Plus there has been some negative comment in the consumer press, which does not help consumer confidence.
Consumers need to be confident that the product they have purchased works for them in the short term and will be durable in the longer term. This is where brokers can drive home their advantage by conducting regular reviews of the customer’s needs as circumstances can change. That last thing we need are worried and confused customers. As with many things one size does not fit all and cases need to be looked at on an individual basis.
Regulatory starting point
Back in 2006 an audit recorded 23,200 mortgages where there was no record of the repayment vehicle. MCOB 11 makes it a clear requirement of lenders to consider a customer’s ability to repay before they enter into a mortgage contract. Plus the FSA has made it clear that for interest only mortgages it expects lenders’ policy to be expanded to include a further three things: how the lender checks the strategy of the customer to repay the mortgage; the plausibility of the customer’s strategy; and how this is taken into account in the affordability calculation. For both lenders and intermediaries, this is pretty unambiguous. This poses some questions for brokers. The level of client documentation, the factfind and notes of client preferences are essential. Good standards of record-keeping is a recurring theme in file reviews conducted by the regulator.
The circumstances surrounding interest only are viewed with such gravity that the FSA published a detailed research report in December 2006. The report was based on 856 telephone interviews conducted between 4-26 September 2006. The sample showed variation across a number of characteristics, demonstrating that holders of interest only mortgages were not a group with similar characteristics. Variations were found in terms of their age, income levels, loan-to-value (LTV) ratio and the size of the loan. A significant minority of borrowers had no idea or definite plan on how they would pay back the capital they borrowed. A large proportion of these borrowers admitted that dealing with finance was best left to the experts, and many had taken an interest only mortgage because it was recommended to them by a professional.
The majority of borrowers who had an interest only mortgage but no repayment plan indicated they did have a recognised repayment plan or other strategy in place to pay back the loan. However, in a number of cases the credibility of this repayment strategy may be open to question. The ability to meet repayments and other commitments is a consideration for mortgage holders; one in five respondents said they would struggle to meet other financial commitments if interest rates rose by one percentage point. A high proportion of respondents had a correct understanding of an interest only mortgage and the majority had a reasonable understanding of the associated risks. All in all, a bit of a mixed bag but not the disaster than some were predicting.
A broken link
Part of the problem is that the link between interest only and other products has been broken. I am not advocating the sale of mortgage endowments, but the policies were actually attached to the lender via the legal process of assignment. With the choice and flexibility in investment products, this link is broken. That flexibility is a two-way street – great in some respects but with drawbacks in others. There is an element of risk attached to stock market-linked investments, so the customer’s attitude to risk is an essential ingredient in the product choice.
Level of information
The key to successful sales of interest only mortgages is the level of information that the customer is provided with – not only through the sales process but the entire life of the mortgage. The customer must be in full possession of the facts and that they need another vehicle to repay the capital at the end of the term. This needs to be reinforced via the annual statement and reminder letters.
One of the fears is that there will be a raft of customers calling at the end of their mortgage term querying why their capital has not been repaid. With the levels of information provided, this seems like a very remote possibility. Talk of a future huge mis-selling scandal is wide of the mark.
Suitability is a far trickier issue. Customers come in differing shapes and sizes. What about the self-employed individual with variable income flows? In this situation, interest only could be a very good option with the client making capital repayments when it suits their individual circumstances. Young professionals are another example, with the possibility of rapid salary increases.
What is more difficult is the vexed issue of affordability. With house prices at an all time high, affordability has never been more stretched. The temptation is that customers could be stretching affordability by using the interest only option.
There is evidence that cases are being submitted citing the sale of the property at some future date. Where the lender’s policy allows it, these cases should carry further safeguards.
Final analysis
Interest only is a further example of the far-reaching flexibility in the UK market. It is an invaluable tool for brokers recommending a truly flexible approach in managing a mortgage. It is true that the regulatory background has tightened, but this is only prudent. It is worth recalling that interest only amounts to about 25 per cent of all new mortgages. The fact is that the ‘one-size fits all’ approach does not work with interest only. With the enhanced levels of information being provided through the life of the mortgage and at the application stage, the customer has little reason to plea ignorance. It is worth reiterating that good record-keeping for lenders and brokers is fundamental in the whole process.
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