Interest-only loans form a significant proportion of the collateral pools for certain legacy U.K. nonconforming and buy-to-let (BTL) residential mortgage-backed securities (RMBS) transactions. Borrowers who have taken out interest-only loans are expected to either refinance them or use a repayment vehicle to pay them off at maturity. However, S&P Global Ratings has observed that more than one-third of borrowers with interest-only loans backing U.K. nonconforming RMBS transactions that it rates have not repaid the principal on their loan's maturity date. We conducted our analysis when borrowers were facing significant rises in their monthly mortgage payments, on the back of successive interest rate hikes by the Bank of England since late 2021.

We examined interest-only mortgage loans in 80 collateral pools in legacy nonconforming and BTL RMBS transactions that we rate. As of the second quarter of 2020, the total balance of interest-only mortgages outstanding due to mature by the end of 2023 in the RMBS transactions we analyzed was £2.53 billion. Between June 2020 and December 2023, we found that 39% of borrowers of these loans by loan count, due to mature in this timeframe, failed to make their final or "bullet" payment at maturity. However, over half of those loans which failed to make the payment at maturity redeemed before December 2023.

In our previous analysis in 2017, 36% of borrowers of loans due to mature between January 2016 and June 2017 failed to make their bullet payment at maturity (see "Third Of Interest-Only Borrowers In Nonconforming RMBS Deals Failed To Make Bullet Payment At Maturity In Past 18 Months"). Of the loans that were scheduled to repay in the half year to the end of June 2016, 21.4% were still outstanding 12 months later. In our current analysis, while 39% of borrowers failed to make their bullet payment at maturity, only 20.1% of loans were outstanding 12 months after the loan's maturity date, showing an overall improvement.

Exit routes for interest-only borrowers have curtailed. Rate rises mean that fewer borrowers will meet criteria for products such as equity release (reverse mortgage) and retirement interest-only. Although we expect rates to fall in the medium term, forecast weak house price growth means borrowers may continue to struggle to redeem their loan at maturity.

Interest-only mortgages were popular from the early 2000s up until the financial crisis in 2008, when borrowers could take them out without providing details of how they would repay them at maturity. According to the Financial Conduct Authority (FCA) in a research note from August 2023, fewer than one million U.K. regulated mortgages are outstanding that are wholly or partly interest-only. The number has dropped rapidly in recent years, halving since 2015 when such mortgages exceeded two million. The FCA also noted the peak years when the largest number of interest-only mortgages are due to mature are 2031 and 2032, with a smaller peak around 2027. This is consistent with the maturity distribution of interest-only loans in our rated U.K. RMBS universe.

Unpaid Loans Have Other Higher Risk Indicators

Interest-only loans often attract borrowers who cannot afford a repayment mortgage of comparable size. Our analysis indicates that many of the interest-only loans that had not been repaid at maturity share similar borrower or loan features.

Borrowers who are above 55 years of age at maturity show a disproportionate tendency not to repay the full balance of their loan at maturity. These borrowers represent approximately 54% of the interest-only loans in the sample analyzed, but 85% of interest-only loans not redeemed at maturity. Furthermore, borrowers who self-certified their income at origination show a disproportionate incidence of nonpayment at maturity. Self-certified borrowers represent approximately 39% of interest-only loans in the sample analyzed, but 54% of interest-only loans not redeemed at maturity (see table 1).

The 39% of missed maturity loans in our analysis translates into approximately 32% owner-occupied loans and 7% BTL loans. We note the redemption performance between owner-occupied and BTL loans is similar across the timeframe analyzed.

That said, borrowers tend to continue paying interest on their mortgage even after missing their bullet payment maturity date. Our analysis shows that the average repayment delay for borrowers who missed their bullet maturity date but made the payment later was approximately eight months.

Chart 1 highlights the improving trend in timely redemption at maturity from 2020 to 2023. This may reflect the benefits of the FCA's modified affordability assessment scheme which was introduced in 2019. The scheme helps to remove the potential regulatory barriers to switching for mortgage prisoners and other borrowers who are up to date with payments on their interest-only mortgage. We also consider that rising rates over this period may have incentivized more borrowers to redeem their mortgage at maturity, given the significant increase in their repayments.

Chart 1

Chart 2 shows the future interest-only maturity distribution across the 80 legacy nonconforming and BTL transactions we analyzed. The proportion of interest-only loans in our sample has increased from our 2017 analysis, as additional interest-only collateral has been securitized in RMBS transactions. The period from 2030 to 2032 represents the greatest risk, with £6.8 billion or 44.95% of outstanding loans due to mature over a three-year time period.

Chart 2

In the U.K. mortgage market between 2000 and 2008, the maximum original term of interest-only mortgages originated across most lenders was typically 30 years. As a result, the maximum maturity we would expect in our analysis would be 2038. However, as chart 2 shows, some maturities fall beyond 2038. These maturities represent loan maturity extensions implemented by lenders and servicers as part of loan restructures agreed with borrowers.

Can Product Evolution Help?

Organic solutions

Many borrowers with interest-only loans have failed to save in a suitable repayment vehicle, while benefitting from a monthly mortgage payment which, up until the current interest rate rise cycle, had fallen significantly from when the loan was borrowed. This is because almost all pre-2008 interest-only loans paid floating-rate interest, linked to the Bank of England base rate or a market index such as three-month term Sterling Overnight Index Average (SONIA; a typical benchmark index used by servicers to set mortgage interest rates). Back then, interest rates were significantly higher up until quite recently. For example, a loan paying LIBOR plus 1.5% borrowed in October 2005 would have initially paid a rate of approximately 6.5%. However, by 2017 for example, the same borrower would be paying approximately 2%. This trend has reversed, with three-month term SONIA, now at 5.22%. If an interest-only borrower falls into arrears and does not meet their final bullet payment, it typically is easier for mortgage servicers to repossess and sell the property.

Mortgage servicers typically contact borrowers approximately two years before the loan maturity, reminding them of their repayment. However, for a cohort of interest-only borrowers, this is likely to be too little, too late.

Given that such borrowers have failed to save for a repayment vehicle while they were of employment age and in a low interest rate environment for years, we do not anticipate that they will be able to save enough money from their earnings to pay off the loan principal as required.

Where borrowers live makes a big difference

When buying property in 2005-2008, some borrowers may have expected house price appreciation to reduce their loan-to-value (LTV) ratio, and so increase their repayment options for the bullet loan.

Data from Nationwide Building Society's house price index indicates that a borrower who bought a house in London in the Q3 2007 for the then-average London house price of £302,000, would now have a property worth £514,000. Even if the borrower took out an interest-only loan in 2007, with an LTV ratio of 80%, they would now have approximately £272,000 of equity (the profit on the house sale plus the original equity) to buy a new house. This would be sufficient, based on Nationwide's calculation of average house prices, to buy a house in every U.K. region, except London, the South East, and South West. Therefore, some borrowers who are geographically mobile and live in areas where house prices exceed the national average and have increased since the loan was borrowed may be able to pay off their loan balance.

Indeed, those in areas such as South East England and London, where prices are materially higher than in the financial crisis, have benefited in this way. Borrowers that have low current LTV ratios have access to refinancing options that are unavailable to borrowers that have higher current LTV ratios. They may be able to access equity release (reverse mortgages), or they can sell the property and either move to a cheaper location or downsize.

Chart 3

However, outside London and the South East, borrowers may struggle to release enough funds to repay the loan and be able to buy a new house (see chart 3). Although downsizing may be an option for borrowers in areas that have seen less house price growth, borrowers' options in such areas will be more limited than in other areas. In our loan sample, 61% of interest-only borrowers whose loans mature by 2034 did not have sufficient property equity at the end of 2023 to buy an average-priced property in their region at current prices without drawing on other equity sources or taking on new debt. In 2012, we found that more than 70% of interest-only borrowers did not have sufficient property equity for the next 10 years to buy an average-priced property in their region (see "U.K. Interest-Only Mortgage Borrowers Could Struggle To Refinance Under Tighter Lending Rules").

Chart 4

This is likely why North East England, Scotland, and Northern Ireland have a disproportionate share of loans that have failed to repay at maturity, relative to their share of total interest-only loans in the sample we analyzed (see chart 5). Of the sample, 21.3% were in the North and North West of England, 7.49% in Scotland, and 1.8% in Northern Ireland. However, these areas accounted for 24.28%, 8.17%, and 3.01%, respectively, of interest-only loans that failed to pay the principal at maturity. For many borrowers outside London and the South East, there remains little hope of an organic solution.

Chart 5

Retirement interest-only and equity release products have become harder exit routes

Across the legacy RMBS transactions we rate, borrowers have increasingly worked with lenders to convert their mortgage structure to a retirement interest-only mortgage (RIO) to avoid the large bullet payment on an interest-only mortgage. An RIO loan is usually paid off when the borrower dies, moves into long-term care, or sells the underlying property. The borrower must make monthly interest payments up until this point, but with interest rates rising borrowers are finding it harder to demonstrate the required affordability to qualify for this loan structure.

Equity release, often in the form of a lifetime mortgage, is a way of accessing cash tied up in a property. With a lifetime mortgage, no repayments are required while the borrower is alive. Instead, interest is 'rolled up', which means the unpaid interest is added to the loan. Similar to an RIO loan, when the last borrower dies or moves into long-term care, the home is sold and the money from the sale is used to pay off the loan. For borrowers with an upcoming interest-only bullet payment, the borrower uses the borrowed lifetime mortgage lump sum to clear their existing interest-only loan. Despite this recent product evolution, with interest rates rising, the LTV ratio which lenders will lend for a lifetime mortgage is lower. This problem is more acute for borrowers outside of London for example, where our analysis demonstrated that they have less equity than borrowers located in the capital.

Mortgage Prisoners And FCA Modified Affordability Assessment

The FCA has identified mortgage prisoners as borrowers who cannot switch and refinance their mortgage to either their current or another lender for a better deal, despite being up to date with their repayments. Consequently, they are paying potentially more than they need to (see "More Than One-Third Of U.K. Legacy Borrowers Are "Mortgage Prisoners""). According to an FCA report from 2020, most difficulties in switching facing mortgage prisoners can be traced back to the major changes to lending practices during and immediately after the financial crisis, and the subsequent regulatory response aimed at preventing a return to past poor practices (e.g., self-certification of income).

This report found that most mortgage prisoners had either interest-only or part-and-part mortgages. Given that many borrowers with interest-only mortgages lack an adequate plan for repaying the capital at maturity, they are likely to be considered high risk and outside the risk appetite of a new lender when attempting to switch.

To combat this somewhat, in 2019 the FCA introduced a modified affordability assessment to help remove the potential regulatory barriers to switching for mortgage prisoners and other borrowers who are up to date with payments. Specifically, the modified affordability assessment allows lenders to simplify their approach to taking on new customers looking to switch to a more affordable mortgage. We expect some legacy interest-only borrowers who have a consistent track record of making timely interest payments on their mortgage to benefit from the updated affordability assessment.

Short-Term Ratings Impact Unlikely For U.K. RMBS

We do not expect to change our ratings on U.K. RMBS transactions exposed to interest-only loans because of this analysis. Our global residential loans criteria apply a higher adjustment for owner-occupied interest-only loans due to mature within five years if we consider the risk to be high for a particular portfolio of interest-only loans. In our analysis, we assume loans that have passed their maturity dates have defaulted and apply a 100% foreclosure frequency assumption. As of December 2023, across the 80 transactions we analyzed, a weighted-average total pool balance of 2.46% of interest-only loans, had missed their maturity date. Since this exposure can vary by transaction, we have captured the credit risk associated with interest-only loans at a transaction level.

Furthermore, the transaction structure is important for junior noteholders. For sequentially paying transactions, when the note balance is less than 10% of the original, the tail risk is borne by the most junior notes. Finally, transactions with non-amortizing reserve funds will offer more protection to noteholders, all other things being equal.

Related Criteria

• Global Methodology And Assumptions: Assessing Pools Of Residential Loans--Europe Supplement, April 4, 2024

Related Research

• European RMBS Index Report Q1 2024, May 16, 2024
• EMEA Structured Finance Chart Book: May 2024, May 9, 2024
• European Structured Finance Outlook 2024: Pushing On Through, Jan. 9, 2024
• U.K. Economic Outlook 2024: More Stagflation Ahead, Nov. 27, 2023
• European RMBS And ABS Monitor Q1 2024, Apr 29, 2024
• Reverse Mortgages In Europe: Product Growth Has Yet To Spur Securitization, July 26, 2023
• S&P Global Ratings Definitions, June 9, 2023
• U.K. Residential Mortgage Servicing Flexibility Could Ease Arrears Pain, April 26, 2023
• Scenario Analysis: How Much Shock Can U.K. RMBS Take?, March 1, 2023
• More Than One-Third Of U.K. Legacy Borrowers Are "Mortgage Prisoners", Sept. 4, 2019
• Third Of Interest-Only Borrowers In Nonconforming RMBS Deals Failed To Make Bullet Payment At Maturity In Past 18 Months, Dec. 18, 2017
• U.K. Interest-Only Mortgage Borrowers Could Struggle To Refinance Under Tighter Lending Rules, July 27, 2012