Ah yes, the latest hot potato for the industry to deal with – the interest only mortgage. It is appropriate for many consumers, and indeed with property prices marching solidly northward, it can often be the only way to meet affordability hurdles. Make sure you advise your clients of the need to factor in a long term repayment vehicle. Full stop. Next topic.
Of course it’s not as simple as that. What has been frustrating though, is senior figures both within and outside the mortgage industry sounding the general alarm about interest only mortgages. Indeed I’m surprised the sky hasn’t fallen down yet. We have seen the headlines, with some claiming that interest only mortgages are set to be the next big mis-selling scandal to hit the financial services industry. Just slightly mellow dramatic. So let’s look at the facts.
Facts and figures
You can see from the graphs over the next few pages that the proportion of interest only mortgages has been rising steadily, while those with capital and repayment option have been falling. The Council of Mortgage Lenders (CML) statistics for buyers using interest only loans without a specific repayment vehicle now account for 15 per cent of first-time buyers and 22 per cent of home movers. As property prices continue to rise, the move toward interest only mortgages is on the increase, largely driven by affordability. Interest only mortgages offer significantly cheaper monthly repayments. On a £150,000 mortgage with a 25-year term, the capital and interest payments at 5 per cent would be £876.89 per month. The same mortgage with interest only option would be £625.00 per month – a monthly saving of £251.89.
The lower interest only monthly payment has significant initial benefits. It allows first-time buyers in particular to get the maximum advance possible, and clearly when getting onto the property ladder, that is a significant, if not deal breaking, advantage. First-time buyers are an important cog in the overall property market, and without stimulus from that sector things would not be as rosy for the UK property market overall. Please note, doom sayers. How many first-time buyers would stay in the same residence for the term of the mortgage? How many wouldn’t move up, require a bigger residence as family needs dictate, move location for employment reasons, get divorced? Whatever the reason, it’s unlikely that the genuine first-time buyer is going to have the same house or mortgage for life. Stephen Knight from GMAC-RFC quoted that more than 90 per cent of mortgages are repaid from some other method than organic repayments. The average life of a mortgage is a closely guarded secret by lenders, but at blackandwhite
.co.uk we estimate from our data that it’s about 3.8 years. That’s another reason why interest only mortgages aren’t so bad – it’s a product that is revisited regularly by both intermediary and customer where a switch to capital and interest can be easily managed as circumstances dictate.
On this basis, interest only mortgages are a much lesser evil than first-time buyers not getting on the property ladder at all. Renting for life anyone? No thanks, and oddly no one is advocating that renting for life is a sensible investment strategy.
Diversification
The other point worth exploring relates to diversification. This is where mortgage broking crosses over into the realms of sensible financial planning but the principles are very straightforward. If your home residence is the only real asset on your balance sheet, that’s not a good long-term risk diversification strategy. Property is a good medium to long-term bet, and it should make up a component of an overall investment strategy. Property prices could fall, so diversifying risk is a sensible strategy. Local and international shares, fixed interest debentures, gold, bonds and cash – where do you start? Well here is a thought – could you not take the £251.89 used in the example above and invest it? There is a well known high-street bank that is currently offering a savings account that pays 10 per cent per annum. Now if you opened that savings account with £251.89 and every year added £3022.68 (12 times £251.89) you would have £327,009.69 in 25 years’ time, twice the original principal borrowed, and you would have diversified your risk in the process. Even at just 5 per cent compound interest you are still ahead of the game. Of course, those early adopters who have jumped on the mortgage offset trail are really only applying the same principles as detailed above.
There is a danger that consumers can become comfortable with the lower monthly payments made possible by interest only mortgages. Again brokers and lenders need to be working the ‘Treating Customers Fairly’ (TCF) angle here. Careful planning needs to be done to establish that there is a mechanism to pay off the mortgage at the end of its term. For some consumers this will be the time to cash in their chips, and downsize or spend their retirement in Costa del Sol or some other sun drenched surrounds. An average £175,000 property bought today would be worth £592,612 in 25 years time at an annual compound growth rate of 5 per cent Again plenty to see off that £150,000 interest only mortgage.
Market performance
Clearly the performance of the housing market is central to this discussion and mitigating the risk of long-term interest only mortgages. My personal view is that property prices will continue to grow for the foreseeable future.
The fundamental factors driving long term property growth are as follows:
A shortage of available housing. The Nationwide estimates that the gap between available housing and the demand for housing amounts to a staggering 48,000 properties per annum;
This problem is being extenuated by an ageing population which is living much longer, thanks to advances in medicines and better understanding of diets. The number of people who were older than 85, grew by 64,000 in 2005 alone, a growth of over 6 per cent in just one year;
There is therefore a lower turn over of housing stock due to rising average ages and falling mortality rates;
The population is growing by organic means and inward immigration, the latter having become a significant factor from 1990 onwards;
The green lobby is becoming ever more successful in blocking new housing developments. The ‘not in my backyarders’ are making life very difficult for property developers and builders;
And finally, there is not much land available to start with – it’s a scarce resource in the UK and that’s not likely to change unless we start filling in the Channel.
All these factors ensure the tension between supply and demand will remain strong, and that will over the medium to long-term, have a sustained upward pressure on property prices. I’m sure the Financial Services Authority (FSA) will be happy if you detail all of the above in your next Key Facts Illustration (KFI) where you have sold an interest only deal. I’m joking of course. But its does underline my view that the property market is in good shape, and all things considered, it’s not a bad place to invest.
Taking the debate futher
It also goes to underline the other key thrust of this article – the debate about interest only or capital and repayment needs to go much further. Diversification of consumers investment risk is a much more significant issue. The rise and rise of equity release mortgages is testament to that fact. We have a whole raft of baby boomers approaching retirement age, who will be living longer and will not have the means to fund an extended retirement without taking up an equity release or lifetime mortgage. Their future lifestyle will in the large part be determined by the ongoing performance of the UK housing market. That is not without its risks as all the eggs will be resting in the property basket, and again highlights the need for diversification at an early stage.
In summary, interest only mortgages have a vital role to play within a robust UK housing market. The growth is being driven by affordability issues and mortgage intermediaries and lenders will need to work together to ensure their clients long-term needs are being satisfied and that we are TCF compliant. There is certainly no need to sound the alarm or for a media frenzy to kick off – just a need to be aware.
