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Box 7
THE INFLUENCE OF MORTGAGE PRODUCT INNOVATIONS ON RISKS TO HOUSEHOLD DEBT
SUSTAINABILITY
In an environment of strong competition, banks in the euro area have been offering new
mortgage products targeted at a larger number of borrowers. With these new products, two
previous obstacles to borrowing have been removed. First, it is now possible in some countries
for households to borrow higher amounts with little or no down payment, through higher loan-
to-value ratios. Second, in a number of countries, other products have become available,
allowing middle and lower-income borrowers to alter repayments relative to their financial
resources, while borrowing larger amounts than might have been possible in the past. This has
mainly been achieved by extending the average loan maturity (up to 30-35 years in some
countries). This Box reviews the specific features of these mortgage products and their
implications for the sustainability of household debt.
1
In many euro area countries, banks are increasingly offering a variety of types of innovative
mortgage products. First, “accordion” variable rate mortgages offer the option of keeping the
monthly instalment constant, even in the case of a change in the interest burden, the adjustment
being made through an extension of the loan maturity. In the euro area, such products exist in
Belgium, Italy, Spain, France and Greece. Second, mortgage products are now increasingly
offering a wide range of flexible repayment options (such as deferred start, payment break or
reduced starting payments), allowing borrowers to match their repayments to their cash flows,
which can be affected by seasonal increases in expenses (for instance, a “payment holiday” can
be granted for one or two months during the summer or at the end of the year). Finally,
“interest-only” or “amortisation free” mortgage loans allow the deferral of the payment of the
principal for a given period or even until the end of the loan.
According to a recent study,
2
interest-only products are now available in most euro area
countries (with the exception of Finland; no information was reported for Austria, Greece and
1 Other types of mortgage products have recently appeared, such as equity release loans, foreign currency loans and reverse
mortgages. However, this Box focuses on innovations that have the greatest impact on households’ monthly repayment burden.
2 See London Economics (2005), “The Costs and Benefits of Integration of EU Mortgage Markets”, Report for the European
Commission, DG Internal Market and Services, August.
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3 See P. J. A. van Els, W. A. van den End and M. C. J. van Rooij (2005), “Financial Behaviour of Dutch Households: Analysis of the
DNB Household Survey 2003”, BIS Papers No 22 – Investigating the Relationship between the Financial and Real Economy, April.
Luxembourg). In the Netherlands survey results indicate that 41% of outstanding mortgages
were interest-only in 2003
3
; they also tend to be more common among lower-income
households. However, it is unlikely that interest-only mortgage loans in the Netherlands are
granted to finance the total value of the property. They are rather often used in combination
with another type of loan, or as a second mortgage, for instance to finance renovations.
Moreover, Dutch banks tend to grant interest-only mortgages with rather conservative loan-to-
value ratios. In Spain, most mortgage lenders now offer a wide range of products with more
flexibility in repayment schemes. They have recently started to grant mortgages under which
borrowers pay only interest for a period of one to three years. In France, loans with a deferred
capital repayment are only granted in special cases (e.g. subsidised loans and student loans).
Interest-only loans, whereby the repayment occurs at the end of the loan duration, are mostly
granted to investors for buy-to-let purposes, to take advantage of particular fiscal schemes.
They are often offered together with an investment product, allowing the lump sum for
repayment to be built up.
Typically, interest-only mortgage products were originally designed for wealthier households,
which tended to use them as a cash management tool – investing the cash freed up during this
period at a higher return – and which were able to sell, if necessary, financial assets to pay off
the loan amount. They were also suited for households with irregular income, but able to make
voluntarily early principal repayments when they have more income, or for young households
expecting their income to rise sharply in the near future. However, for many “ordinary”
borrowers, such flexible mortgage products have now become the best financing option,
allowing them to overcome the financial hurdle to home ownership brought about by the recent
increase in house prices, and to adapt their repayments to the pattern of their financial
resources.
However, innovative mortgage products do potentially contain certain specific risks. A longer
loan duration and amortisation period entail a higher probability that the household could face
debt sustainability problems, for instance caused by a period of unemployment with a lower
income, or loss of income altogether. With regard to interest-only loans, they might be a good
choice for buyers intending to move or refinance – and therefore repay the principal – before or
at the end of the interest-only period. However, after the initial amortisation-free period,
borrowers could face a sudden, sharp increase in their financial burden for which they might be
unprepared. Moreover, should house prices decline, there is a higher risk that households
would be left with low or even negative net housing equity, the outstanding balance of the loan
exceeding the value of their houses. Finally, the total amount of interest paid will be higher
over the term of the loan.
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In the euro area, quantitative information on these new mortgage products is scarce, making it
difficult to assess the overall financial stability implications. However, some lessons can be
drawn from recent developments in the US, where the growing popularity of interest-only
mortgages has recently raised financial stability concerns.
4
Interest-only mortgages (deferring
principal payments for a period of three to ten years) are now being offered by most lenders,
and represented a third of home purchase loans originated in 2004
5
, up from 5% in 2003.
However, the amortisation-free period is substantially longer than in the euro area (up to half
the total duration of the loan), potentially resulting in a high increase in the monthly payments
at the end of this initial period (anecdotal evidence suggests that the monthly payment could
jump by 50%, even in the absence of any interest rate rise).
Available products in the US also include option adjustable rate mortgages (ARMs), or flexible
ARMs, allowing the borrower to choose a repayment scheme whereby payments in the initial
period (five to ten years) might cover in extreme cases only a part of the interest payment, the
remainder being added to the outstanding loan balance to be repaid later. There are also
concerns that these higher-risk ARMs are increasingly being offered to riskier borrowers, who
may face greater difficulties adjusting to the rise in their monthly payments at the end of the
initial period. However, at present such products, which could potentially result in a
“negative” amortisation of the loan (meaning that the outstanding balance increases over time
instead of decreasing, as a result of accumulated deferred interest payments), do not appear to
be available in the euro area.
From a financial stability viewpoint, while the innovative mortgage products that are
becoming increasingly available in the euro area allow households to keep their monthly debt
servicing burdens at reasonable levels in the short run, longer-term risks could be increasing,
especially as the ability of households to make large principal repayments after a considerable
period of time is largely untested. This would call for closer monitoring of how the nature of
risk-sharing in mortgage lending is being altered by product innovation.
4 See Federal Reserve Board, Monetary Policy Report submitted to Congress on 20 July 2005, which states that “Recently there has
been increased use of potentially riskier types of mortgages, including adjustable-rate and interest-only loans, which could pose
challenges to both lenders and borrowers.”
5 According to data from the real estate information firm Loan Performance (see for instance the annual report on “The State of the
Nation’s Housing 2005”, issued by the Joint Center for Housing Studies at Harvard University). These data refer to loans packaged
for resale as mortgage-backed securities, and thus do not cover the entire market.
