Retirement interest-only (RIO) mortgages are a product that should play into the natural strengths of building societies: a high degree of careful manual underwriting and relentless focus on customer need.The BSA is pleased that the FCA acted quickly to bring RIO mortgages into the rulebook after recognising during their ageing population work that these products could provide a good solution for some customers.
Showing the interest within the sector, twenty-seven building societies recently attended a roundtable with the FCA architects of the rule changes. During the event, it became clear that societies are keen to think through what extra consumer protections these products might need. While it will be up to each lender to think through the risks, here are a few thoughts.
Looking at the MCOB amendments the standout change is the additional guidance under 11.6.15, which states that:
'When assessing the affordability of a retirement interest-only mortgage with joint borrowers, the firm should consider the ability of a single borrower to continue making the required payments if the other dies, taking into account relevant evidence such as pensions payable to the surviving spouse or civil partner'
We welcome the additional clarity this provides and, certainly, it is good practice to check how much pension income would transfer across to a surviving borrower if the higher-earning partner were to pass away.
However, we know from speaking to experienced advisers in the retirement lending space that, in real life, many joint borrowers say they would not want to live in the same home if their partner died. It may be too large for their needs, or feel too empty.
Essentially, as long as the lender is satisfied that the property would provide sufficient equity to realistically downsize after first death, could they offer a product on this basis? The rules appear to leave this open. Of course there is always the risk that a borrower will say today that they intend to downsize but change their mind in future. It will be up to lenders whether they are comfortable with this risk.
Another interesting point on affordability concerns sources of pension income, where the rules are un-prescriptive. The consultation feedback was clear that '[RIO mortgages] will not be appropriate for older customers who cannot demonstrate their ongoing ability to afford to make interest payments.' Yet lenders may ask – how does this work in a world of pension freedoms?
Under pension freedoms, ongoing affordability relies on the borrower's choice. They essentially take on responsibility for generating an income out of their pension pot, with the longevity and investment risk. Lenders can only make a decision on the information in front of them at the time and assume the borrower will act reasonably. However, for a bit of peace of mind best practice might involve signposting customers to a Government service such as Pension Wise to make sure they really understand their options under pension freedoms.
Following on from these thoughts about pension freedoms comes the question – what else can lenders do today to future-proof? One of the less tangible areas is mental capacity.
Building societies have worked hard on their policies and practices for vulnerable customers over the past few years. Working with charities to make branches 'dementia-friendly' or auditing their call centres and record-keeping processes have been central to this.
Vulnerability policy becomes business-critical when lending indeterminately. It is inevitable that some of the people firms lend to today, will develop some form of dementia in future. The sad fact is that a person's risk of developing dementia rises to one in six over the age of 80.
One way customers can address this risk is through a Lasting Power of Attorney (LPA). To link back to the previous point: in a time where more customers are taking on the risk of generating income from their pension pot, a loss of mental capacity could leave them in serious financial difficulty.
For this very reason, a couple of societies already selling RIO mortgages offer a discounted rate for customers who register an LPA. This common sense promotion incentivises customers to plan for the future and prepare for the worst.
The final thing to consider is one building societies cannot do much about: that is the path of future interest rates.
In some ways, a RIO mortgage is similar to a lifetime mortgage. Pricing, however, is very different. With a lifetime mortgage, the rate is fixed for the whole life of the loan. For societies on a traditional or limited prudential approach, there is no way the PRA would allow this. Arguably, even the largest high-street lenders would struggle.
The FCA has made RIO mortgages part of the standard MCOB framework. Stress-testing a RIO mortgage against rate rises is therefore just as important. Arguably it is even more important, as the borrower is likely to be on a largely fixed income from their pension or other investments, and until a remortgage market develops their options may be limited when they come to the end of their initial deal.
While lifetime fixed rates are not in the building society arsenal, could a lifetime-discounted rate protect borrowers against potential interest rate shocks in future?
Of course, it is the responsibility of the borrower to keep up interest payments and repossession is an option if they fail to do this. Another option would be to transition into a lifetime mortgage. However, caution is needed against assuming at the outset that this will always be an option. Lifetime mortgages are very sensitive to loan-to-value bands and just a few years of falling house prices during the life of the RIO mortgage could change the arithmetic substantially.
Originally published as part of Mortgage Matters - to receive Mortgage Matters, please update your preferences.