An interest-only mortgage time bomb has been ticking for several years now and there are fears it’s about to go off.
We’ve known trouble has been coming since about 2008, but the City watchdog is now so worried about the number of people at risk of losing their homes over the next few years when they cannot clear debts at the end of their mortgage, that it’s prepared to U-turn on European rules brought in just 18 months ago.
These made it virtually impossible for older borrowers to renew their interest-only mortgages – even when they were happily meeting their monthly payments without a problem.
Now that these home owners face a repayment D-day the UK authorities have been forced to act.
Are you thinking about equity release? It could be worth waiting until the new loans launch
In early September, the Financial Conduct Authority revealed plans to bring back interest-only mortgages for older borrowers.
It is worried that nearly two million people currently sitting on an interest-only mortgage have no way to repay it other than by selling up, leaving them with too little left over to buy somewhere smaller to live.
Why is there an interest-only time bomb?
There are approximately 1.9 million borrowers in the UK on interest-only, a type of mortgage that became very popular in the 1980s, 1990s and early 2000s.
It was initially driven by the rise of endowments – opaque investments plan designed to pay off the debt – but their later lacklustre performance and the 2000s property boom then saw many dished out with no repayment vehicle in place at all.
Interest-only was effectively phased out by lenders for most new loans as tighter mortgage rules were brought in from 2014.
On interest-only, borrowers pay off only the interest on the mortgage each month, and then must clear the capital balance in full with a lump sum when the mortgage’s life comes to its end.
So if you took a 25-year £100,000 interest-only loan in 1992, you’d have paid interest every month but you’ll still need to repay £100,000 this year.
Under lax lending standards before the financial crisis, many people were given these loans without being asked to think about how they’d repay them at the end.
Under current mortgage rules, they can’t get a new mortgage to refinance their debt
But under current mortgage rules, they can’t get a new mortgage to refinance their debt unless they can prove they have a reasonable ‘repayment strategy’.
This includes savings, investments, another property or enough equity in their home to fund downsizing.
This is fine for some of these homeowners, but estimates suggest at least 30,000 interest-only borrowers will owe their lender more than 75 per cent of the value of their property when their loans end.
Not only can they not get a new mortgage, they also may not qualify for equity release and it’s unlikely they could buy somewhere else to live with the money left over.
The FCA’s proposed changes mean borrowers will be able to remortgage onto an interest-only mortgage without having to show they have any of the above repayment strategies.
Instead, they will repay the balance when they go into care or die and their home is sold.
Such retirement interest-only loans are currently under consultation, but a final decision is expected from the regulator in mid-November, meaning they are likely to be available from early next year.
What’s the difference between a retirement interest-only mortgage and a lifetime mortgage?
The FCA defines the new retirement mortgages as ‘interest-only mortgages for older consumers where, assuming there is no default, the loan is only repaid on a specified life event, usually the customer’s death or move into residential care’.
Customers must still be able to afford the ongoing interest payments, but ultimately the loan is repaid through the sale of the property.
A lifetime mortgage on the other hand is a form of equity release.
Borrowers choosing this option can opt either to pay interest monthly for as long as they wish and then switch to a roll-up plan, or go straight to rolling interest up.
The advantage of roll-up is that there are no monthly payments, so it can be an option for borrowers with low incomes.
The disadvantage is that interest charges compound over the years which can eat into homeowners’ equity significantly, leaving little to pay for care in later life or to pass on to children.
Equity release rates are also higher than standard mortgage rates as they factor in longevity risk – how long you’re likely to live before the lender gets their money back.
Despite coming down over recent years, equity release rates are still between 3.6 per cent and 6 per cent and the maximum you can borrow is 55 per cent of the value of your home.
That’s fine if you own your home outright when you take the loan, but if you have a 75 per cent LTV interest-only mortgage to pay off, equity release isn’t going to help you.
While there’s no guarantee retirement mortgage rates will be priced more cheaply than equity release, because you are paying off the interest, it’s going to be a significantly cheaper option over the long-term and allows you to protect the equity in your home.
What should I do now?
FIND OUT ABOUT EQUITY RELEASE
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There’s no right answer to this, and it will depend on your personal circumstances, but if you’re thinking about equity release, speak to an independent adviser to find out what your current options are and then weigh those up against what you’re paying now on your interest-only deal.
Imagine if that was to be extended by your lender.
If your interest-only mortgage term is coming to an end in the next three or four months, talk to your lender now and find out if they will extend your term in light of this consultation on the interest-only rules.
An independent mortgage broker will also be able to review your situation and advise you on what steps to take next.
But as a rule of thumb, if you can delay the decision to repay until next year when you’ll likely have more choices available, it’s probably worth it.
Why would I ever take equity release if I can get interest-only cheaper?
A good question. Equity release will stick around after retirement interest-only makes a come back, but it’s always going to remain a niche product.
This is partly because it’s only available to homeowners over the age of 55 who have lots of equity in their homes and are prepared to spend it.
Those who have less equity or who want to protect it to pass on as inheritance will struggle to justify equity release.
It is going to continue to be useful for those who want an income generated by their property however.
The new retirement mortgages will require a monthly repayment, so they won’t be affordable by everyone.
Interest-only Mortgage Timebomb Calculator
This calculator shows borrowers with no plan to repay an interest-only loan, or whose investments have fallen short, how much extra you may have to find if your lender forced you on to a repayment mortgage.
Is there a future for equity release then?
Companies such as Legal & General, More 2 Life, LV=, Aviva, Just, OneFamily and Retirement Advantage specialise in equity release, a market which has grown quickly over the past few years as more borrowers with interest-only mortgages use it to repay their balances.
Indeed, at the moment Santander customers whose interest-only mortgages are maturing are typically referred straight to Legal & General advisers to consider moving to a lifetime mortgage.
I think this could have an impact on demand for equity release if it does proceed.
However, this could change.
The retirement interest-only mortgage is likely to be offered predominantly by traditional mortgage lenders – banks and building societies.
The way they fund these loans is different from insurers, and it might mean they can keep rates lower than on lifetime mortgages.
If this is the case, it could be that demand for equity release takes a hit.
The Equity Release Council currently anticipates that gross lending through equity release will hit £3billion in 2017 – that’s more than doubled over the past 10 years and has been driven largely by a combination of rising house prices and borrowers needing to pay off interest-only loans.
If homeowners are given another, cheaper option, we may see this rate of growth slow.
Dean Mirfin, of equity release advisers Key Retirement, said: ‘Customer needs are changing and it is vital that lending solutions available to older borrowers continue to evolve and our sector is one which is working hard to do this.
‘The wide range of solutions available are clearly meeting the needs of many borrowers, however, as the latest consultation from the FCA shows, even wider solutions are needed for those in particular who have higher loan-to-values.
‘Unfortunately as many enter retirement they will no longer have the capability to afford a traditional mortgage and therefore the market still needs to look for solutions to meet the needs of these borrowers.
‘But those with larger interest-only loans require new approaches if they are to be helped.’
Adam Carnell, of retirement specialist Age Partnership, added: ‘I think this could have an impact on demand for equity release if it does proceed.
‘And it could allow some lenders and building societies to potentially move clients in volume without advice onto an alternative product which may be a danger. This heightens the need for holistic advice so that clients are fully aware of all the options before they proceed.’