Traditionally, banks have offered mortgage terms of 25 years to buyers, a long enough time so that buyers can have both low monthly payments and a moderate level of total interest paid. In recent years however, there has been a trend towards mortgage loans of even longer terms, those 35 years or longer in the UK mortgage market. By extending the duration of loans, banks have reduced the amount borrowers pay as monthly instalments, thus making housing appear more affordable in the short run. Despite its apparent benefits however, the Prudential Regulation Authority (PRA) of the Bank of England has issued warnings about these loans and their risks and consequences.
Earlier this week, in a speech intended to be delivered in May but pushed back due to the election, head of the PRA, Sam Woods warned lenders about offering long term mortgages. With mortgages of over 35 years, there is an increase likelihood that the later instalments would have to be paid with post retirement income. Woods and the agency believes that this dramatically increases the risk of these mortgages since post retirement income can be substantially smaller. In addition, increasing the loan term also means that the total amount of interest paid on the mortgage would be far greater because of the way interest compounds. For example, with a moderate mortgage of £250,000, and a down payment of £500 and interest rates averaging 4.5%, the total repayments for a 25 year loan would be £417,350, whereas the total repayments for a 35 year loan would be up to £497,400.
Repaying mortgage from post retirement income shouldn’t be a problem if “lenders can be confident about the availability of such retirement income, or about the scope for the borrower to downsize and use the sale of the proceeds to pay off the balance of the loan”. This is the case in countries like Japan and Switzerland where mortgages are even often passed down to the heirs who inherit the properties. However, the PRA notes that in the current environment, this certainty of information may not exist. Lenders have become too concerned with competition, and with meeting mortgage market review affordability rules set for the first five years, that they have ignored many series concerns raised by 35 year mortgages.
Mr. Woods puts these new lending practices into broader context by saying that while practices such as increase the loan term “rightly put affordability at the heat of mortgage lending decisions, as with any rules of regulations, complying with the spirit as well as the letter of the law is important”. He also warns about various other risky lending activities undertaken by banks such as offering a greater amount of mortgages with Loan to Value ratios of more than 90%. Overall, the PRA believes that greater caution and less risk is needed in the UK mortgage market.