LONDON The Financial Conduct Authority (FCA) has asked mortgage lenders to check if customers can pay back the loans, stepping in early to head off possible defaults in a sector the government sees as key to reviving growth.
The FCA said the capital on 2.6 million interest-only home loans will be due for repayment over the next 30 years, with 10 percent of those having no strategy for paying back the money.
Nearly half of the loans, which only pay off the interest on the loan and not the capital, face a shortfall averaging 71,850 pounds, with customers "over-optimistic" about their ability to pay, the watchdog said.
The FCA was launched last month with a specific remit to protect consumers and end a history of mis-selling financial products, including endowment mortgages and pensions, stretching back two decades or more.
The FCA aims to head off problems earlier, rather than waiting for problems to gather critical mass before intervening, as regulators did in the past.
The sluggish economy's squeeze on household income is already prompting some borrowers to switch to an interest-only mortgage because of the lower monthly payments.
Interest-only mortgages allow home buyers to only repay the interest each month, has been sparked by a crackdown on affordability checks, due to come into force next year.
"By acting now we are aiming to nip this problem in the bud," FCA chief executive Martin Wheatley said in a statement.
Britain's Council of Mortgage Lenders said its members will be stepping up contacts with borrowers of interest-only loans.
"Most people, even if they have not yet done so, have time to plan a satisfactory strategy for when their mortgages reaches maturity," CML director general Paul Smee said.
FCA officials said lenders will ask their customers if they could afford to switch to a standard home loan where monthly repayments include interest and capital.
The watchdog has been given new powers to ban products but for now is holding back on introducing mandatory rules.
Instead, it has set out guidance on how lenders should deal with interest-only mortgage customers who risk being unable to pay back the capital.
Wheatley has in the past described interest-only home loans as a "ticking time-bomb", but banks, who already face a compensation bill of over 12 billion pounds for mis-selling loan insurance, will be relieved by findings on interest-only loans.
Two studies commissioned by the FCA and released on Thursday do not point to a new mis-selling scandal brewing, and show there has been no surge in complaints, a classic indicator of a serious problem, the watchdog said.
Only 2.5 percent of customers with interest-only mortgages said they were not aware they needed a repayment plan and don't have one in place, the FCA studies showed.
Tighter rules on all home loans will be introduced in April 2014 by the FCA, such as closer scrutiny of a borrower's ability to repay the money.
Many banks no longer offer interest-only mortgages and those that still do have tightened their conditions.
(Reporting by Huw Jones; Editing by Louise Heavens)