Both Lloyds and Santander have now introduced strict new rules for interest-only mortgages. Will other lenders follow suit?

In the last week Santander and now Lloyds have introduced a number of strict new rules for interest-only mortgages, seriously restricting who is eligible to get one.

We explain exactly what has happened and why.

What is an interest-only mortgage?

With an interest-only mortgage – as the name suggests – you only have to pay the interest on your loan each month.

As a result your monthly repayments are much cheaper than if you have a repayment mortgage – which requires you to pay off part of the loan each month as well.

However, whereas with a repayment mortgage you will own your home at the end of the term, at the end of an interest-only deal you will be left with the loan still to pay off.

What is the problem with this type of mortgage?

A few years back the regulations surrounding interest-only mortgages were loosened and lenders were no longer obligated to check people had a suitable payment plan in place to clear their loan at the end of the mortgage term.

At the height of the market interest-only loans accounted for a third of all mortgage sales – of which some 75% had no reported repayment strategy.

People began to use this type of mortgage to stretch their affordability on the assumption that house prices would continue to rise…which they didn’t.

Others had been sold an endowment policy – a long term investment and life insurance product designed to pay out enough to cover the loan. Yet, endowments performed badly and from 2000 onwards millions of people were left with serious shortfalls.

What is the regulator doing?

Following the house price crash of 2007, the FSA began to consult on new regulations to crack down on risky mortgage lending and stop people borrowing more than they can afford to pay back.

In its first mortgage market review, the FSA went as far as to suggest that interest-only mortgages should be banned entirely.

However, in December last year the FSA toned down its initial requirements, acknowledging that there is still a strong market for interest-only mortgages.

The FSA has also climbed down from its original proposal for lenders to check in with their interest-only customers every year to make sure their repayment vehicle is on track, reducing this requirement to once during the mortgage term.

Why are the lenders so worried?

Even though the FSA has backtracked on its proposals, lenders are concerned that by putting the onus back on them to check repayment vehicles are on track, they are at risk of being sued if a customers’ investment does not perform, Ray Boulger, of mortgage broker John Charcol, explained.

With uncertainty about how investments will perform in the current environment, therefore, they are opting now for a very risk-free approach.

What is Lloyds doing?

As of today, Lloyds will no longer view cash savings, including cash ISAs, as an acceptable way to repay an interest-only mortgage at the end of the term.

According to Lloyds cash savings are ‘too fluid’ in comparison to investment vehicles such as endowments and stocks and shares ISAs which are longer term strategies.

Customers must also have a minimum of £50,000 invested, and can only borrow up to 80% of the total value of their investment.

For example, if you had £100,000 in a stocks and shares ISA, Lloyds will only lend you up to a maximum of £80,000.

Those using their pension as a repayment vehicle, meanwhile, must have more than £1 million invested, and can only borrow up to 25% of the total fund.

The new rules will apply to all new customers, as well as existing customers who want to ‘port’ their rate – move house while keeping their existing rate. Customers who just want to get a new product but remain in their current house, however, will not be affected.

And Santander?

The majority of lenders allow you to borrow up to 75% of a property’s value on an interest-only basis, but last Friday Santander became the first high street bank to increase this deposit requirement to 50%.

This means that if you are buying a house worth £100,000 you need to stump up £50,000 as a deposit or have £50,000 worth of equity in your home.

However, the new rule will not apply to existing customers unless they want to move home or take out additional lending. In this case they will be switched onto a repayment mortgage.

What about the rest?

Most lenders have now tightened their interest-only lending requirements. Property price inflation and expected inheritance payouts, for example, are no longer considered an acceptable repayment strategy.

Meanwhile, like Lloyds, Barclays’ mortgage arm Woolwich also refuses to accept cash savings as a repayment vehicle.

And while it will accept equity ISAs it will assume 0% growth. Customers must also have been contributing for at least 12 months before taking out the mortgage.

Will other mortgage lenders follow suit?

It’s very likely more changes are on their way.

According to Boulger, now that three of the top five lenders have clamped down it would be ‘surprising’ if other major lenders don’t follow suit.

Though, with all lenders introducing different changes it is difficult to predict exactly what they are going do.

Meanwhile, if all of the big lenders introduce changes smaller lenders won’t be able to afford not to change as well, Boulger said. ‘Otherwise their business will be skewed towards doing what the big boys won’t touch.’

However, smaller lenders will be able to look at individual cases rather than rely on computer driven risk assessments so there may still be a place for people outside the scope of major lenders, he added.

Is there still a place for interest-only mortgages?

For most people the repayment option will be the best option.

However, the FSA has acknowledged that there is still a place for interest-only loans as a 'niche product', citing rational examples of when it is appropriate for someone to take out this type of mortgage – people with a defined repayment from an investment or who plan to downsize, for example.

If it doesn’t want to demolish the interest-only market altogether, therefore, the FSA needs to address the cause of recent clampdown by big lenders and discuss ways lenders can be more accommodating, Boulger said.

One solution, for example, might be to introduce longer mortgage terms, Boulger suggested. With the retirement age likely to be around 70 for people currently in their thirties, increasing the mortgage term from the typical 25 years to 35 or 40 years would mean you will have still cleared your debt by retirement.

The consulting period on the current mortgage review ends on 30 March, with the new rules expected to come into force next year.