The ‘interest only’ time bomb

by George Hatjoullis

A very disturbing FT article ( published 27/10/2014 revealed that about one-third of outstanding mortgages are interest only. Most of these were take-out in the last 20 years. One of the most disturbing aspects of the article is that some people appear not to be aware of that their mortgage is interest only. The majority of borrowers have made some provision for repayment though given the volatility of financial markets for much of the last 20 years one wonders whether the provision will prove adequate. The tone of the article is that, for a significant proportion of borrowers, provision may not prove adequate. It will become a problem for those that have not covered the loan through alternative means and where the loan is maturing. Many will, as the article suggests, be at or close to retirement. What happens if there is a shortfall?

Given the recent surge in house prices it is likely that the net equity is positive. A sale of the property will clear the loan and leave the borrower with a tidy sum. However, unless the borrower wishes to sell and move somewhere cheaper or rent, this is not satisfactory. The borrower may still be able to meet interest payments but as the mortgage is maturing she will need to re-mortgage the property. Herein lies the problem. Lenders are not keen to extend mortgage loans to people of a certain age irrespective of the equity. Indeed lenders are now bound by regulator requirements to be quite strict when providing mortgages. Re-mortgaging may prove a problem for retiring interest-only borrowers that have made inadequate provision.

The temptation may be to use sums that have been saved for retirement income to settle the mortgage. One temptation may be to use the soon to be available freedoms to access direct contribution pension savings. This could prove very expensive as only 25% can be accessed tax-free. The other 75% will treated as income in the year accessed and could be taxed at the higher marginal tax rate. It also eliminates the proposed IHT advantages of defined contribution pension plans. It will also leave the retiree short of expected pension income. The conclusion is that such retirees have not saved enough for retirement but that does not help matters. If they have justified this by ‘my house is my pension’ then the time has come to sell up and downsize. The financial services industry will no doubt try to resolve the matter through another product such as a life-time mortgage, but this may not be suitable and could prove very expensive. Selling and downsizing recognises the situation and the error.

The situation is made even worse if new property taxes, such as the mansion tax,are introduced. The point of interest is that some people will have substantial equity in their home, an interest only mortgage and will be coming up to, or be in, retirement. They may have made inadequate provision to repay the mortgage and face a retirement income shortfall unless they sell the property. The prospect of property taxes exacerbates the problem for some. There are two potential implications.

First, this is another pressure for house sales on top of an steady accumulation of such pressures. Second, there may yet be another ‘mis-selling scandal’ as lenders are held to account for yet another failure by borrowers to think through the risks in their leveraged investment in property and other markets. This is especially true for those borrowers that were somehow unaware that they had an interest only mortgage.