U.K. borrowers are refinancing their interest-only mortgages nearly as fast as they refinance mortgages that amortize, and this is reducing the risk in non-conforming residential mortgage-backed securities, according to Moody’s Investors Service.

“As most interest-only loans continue to repay ahead of maturity dates, RMBS pools grow less vulnerable to high concentrations of interest-only loans, and thus to interest-rate increases and refinancing risk,” Steven Becker, a structured finance analyst, stated in a report published Tuesday.

Moody's expects this trend to continue as the U.K. economy recovers.

Loans that allow borrowers to make only interest payments until they mature are considered riskier than loans in which the principal is paid off gradually, since borrowers tend to have less equity in their homes. There’s also a greater risk that borrowers won’t be able to pay off the loan when they sell the property if its value has fallen.

And since U.K. mortgages tend to be floating rate, as opposed to fixed rate, a rising concentration of interest-only loans would put RMBS more at risk to rises in interest rates, which could make payments for borrowers less affordable and make it more difficult for borrowers to refinance or sell.

However, to date, 63% of interest-only loans originally included in U.K. non-conforming transactions have left the pool, only 13% below the rate for amortising loans.

Back-ended concentration risk is also reduced by early repayment.  The practice of originating most interest-only loans with terms of 25 years prompted a large repayment concentration around 2030, when more than 8 billion of the interest-only loans were due to mature. To date, this anticipated repayment risk has more than halved to 3 billion because of early repayment.

However, Moody’s notes that interest-only loans face marginally higher default rates than amortising loans because they historically have higher loan-to-value (LTV) ratios. Default rates are less than 2.4% higher on interest-only loans than on amortizing loans, owing to the high proportion of interest-only loans in which the homeowners has borrowed more than 80% of the value of the property.

Moody’s predicts that future interest-only loans will ultimately suffer higher default rates because of high loan-to-value exposure, reaching 24.6%, while amortizing loans are expected to have a 20.3% default rate.  Becker adds, “Marginally lower repayment rates on high loan-to-value interest-only loans leaves some limited tail-risk exposure in U.K. non-conforming RMBS.”

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