How the interest-only timebomb could hit the housing market

published 8 October 2012

Once deemed a perfectly sensible way to get on the property ladder', interest-only mortgages are now pariah products.

Lenders around Britain are clamping down on their criteria for issuing them. Last week, Nationwide went even further. The building society has now stopped offering interest-only loans to new borrowers at all.

I don't see this having a huge impact on new lending. Interest-only has already collapsed in terms of the share of new home loans issued. Nationwide might be the first to outright ban them, but most lenders have imposed such tight conditions on these loans that they are effectively banned.

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No, the real problem with interest-only loans is the impact on people who already have them

The next great banking scandal'

Before the house price crash in 2008, anyone buying a house had the choice of two basic mortgage types. Your standard home loan the repayment mortgage saw you pay the interest on the loan, plus a bit of the loan itself, every month. As a result, by the time the mortgage term usually 25 years was up, you'd have paid off the house.

Interest-only was very different. Each month, you'd just pay the interest on the loan. At the end of the term, you'd have to cough up the original loan itself. Clearly, the idea was that you would somehow be saving money for that day over the period of the mortgage.

Of course, these aren't new products. The notorious endowment' mortgage, for example, was based on the idea that money invested in the stock market would grow faster than money stuck in the bank.

So you'd pay the interest on your mortgage loan each month, and stick some money in the stock market too. By the end of your mortgage term, you'd have enough in the investment pot to pay off your home loan, and a bit left over to go on holiday or buy a car, or whatever.

It didn't always work out like that, as some people (and often their financial advisers), learned to their cost. Indeed, it resulted in a huge mis-selling scandal.

What's really worrying the banks now, is that interest-only could end up being a far bigger mis-selling scandal. At least with endowment mortgages, there was some sort of vehicle put in place that was meant to pay off the original loan.

During the run-up to the housing crash, interest-only loans were being written without a care in the world as to how the initial capital would be repaid down the line. At the peak in 2007, one in three new loans were written on an interest-only basis, according to the Financial Services Authority.

"Experts believe one million interest-only mortgages will come to the end of their term between now and 2020 with no repayment plan in place," notes Jeff Prestridge in the Mail. It could be "the next great banking scandal'".

Mis-selling or over-optimism?

Now, excluding cases of out-and-out fraud, I don't have a great deal of sympathy for anyone who believes they were mis-sold' an interest-only mortgage.

That might seem unfair. But there is so much information available out there about home loans. I find it hard to believe that many of the people who took out interest-only loans didn't understand what they were buying.

Anyone who did even a cursory Google search for the relevant terms would have rapidly spotted the difference between an interest-only and a repayment mortgage. If you didn't know that you'd have to repay the initial capital at some point down the line, then you can't have been paying much attention.

What buyers might well have got wrong and where they might now be looking for someone to blame - were their assumptions.

They assumed that house prices would keep rising. They assumed that inflation would reduce the initial price of the house to a laughably small amount by the time redemption day came around in 25 years' time. They assumed that something would turn up'.

That's unfortunate, but it's not necessarily mis-selling.

But with regulators feeling aggressive, and the financial industry (rightly, in most cases) under constant attack, you can see why banks are worried. Every unbacked interest-only mortgage they sold must now look like a potential legal liability just squatting there menacingly on their already wobbly balance sheets.

The other big problem the potential for default

Of course, this isn't the only worry for banks. There's the more straightforward concern that people on interest-only mortgages might not be able to repay the original loan. That'd be bad news for bank balance sheets too. So it's little wonder that they are increasingly keen to shift people from interest-only to repayment loans.

But as Simon Lambert points out on thisismoney.co.uk, this will mean a very rude awakening for anyone on interest-only who has to borrow more money to move home, or who wants to remortgage at a lower rate.

They'll find that more than likely, they'll have to move over to a repayment loan. And that could be a big shock. "A borrower with a £150,000 mortgage at 4% would have to find an extra £420 a month to move from an interest-only mortgage to a repayment deal."

At the very least, these people will be mortgage prisoners' unable to move, and making the market even more sluggish than it currently is. At worst, these people may lose their homes down the line, helping to push down prices overall.

It's yet another reason why we think the UK housing market is heading for another slump. To find out more, you can sign up to Money Morning and read our report about it. We'd also be very wary of buying into the big rally in UK housebuilders, as my colleague Phil Oakley noted last week. And finally, it's yet another cloud hanging over the banking sector we'd avoid those stocks too.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.