Jan 04 - Headline figures on arrears may underestimate the risk profile of mortgages given the high proportion of interest-only mortgage loans outstanding in the UK market, Fitch Ratings says.
The credit quality of UK mortgage portfolios is likely to deteriorate over the coming years, particularly as interest rates begin to rise and place stress on interest-only loans extended for affordability considerations or as a forbearance measure. Over 40% of all loans secured on homes are extended on this basis according to the Financial Services Authority, even though a number of lenders temporarily withdrew interest-only products in Q412. The very low base rates have benefited borrowers, but as these loans mature impairments are likely to rise because over three-quarters of these loans do not have a reported repayment strategy.
The average default probability of interest-only mortgages can be up to 40% higher than repayment products due to the increased risks that arise from a bullet payment. Limited refinancing options will also contribute to higher default risks.
The rising credit and conduct risks from interest-only mortgages are manageable for the banks and building societies we rate. The expected increase in arrears has been taken into account in the ratings downgrades across UK mortgages lenders over the past 18 months.
Interest-rate only products are now extended under tighter underwriting standards, which should improve the quality of new lending. But it will not benefit the loans already present in lenders’ portfolios. Evidence so far shows that the loan term has been extended for most maturing loans that cannot be repaid, with no disclosure of whether the loan would have defaulted otherwise. Mortgage lenders have begun to pro-actively help borrowers plan for the maturity of interest-only mortgages. From April 2014, new loans can only be extended with a credible repayment strategy under the Mortgage Market Review rules.
Around GBP120bn of interest-only mortgages are due for repayment by end-2020 (1.5 million accounts in total). Most interest-only mortgages were extended because they were more affordable during a period of high loan growth, excessive borrowing by households and weak underwriting criteria by lenders. In addition, as the UK authorities have encouraged forbearance in the negative macroeconomic environment, a number of repayment loans were converted to interest-only as a temporary forbearance measure.