Interest-only mortgages will become "obsolete" if the City watchdog presses ahead with new rules for the product, a trade body warned today.
Lenders will withdraw from the interest-only market if the Financial Services Authority (FSA) implements draft proposals for the sector, the Intermediary Mortgage Lenders Association (IMLA) said.
The FSA has signalled that it plans to introduce tougher regulations for interest-only mortgages, including making lenders assess affordability for the loans on a repayment rather than an interest-only basis.
The regulator has not set out its full proposals for the area yet, but it is also expected to call on lenders to check that borrowers have a repayment plan in place on an annual basis, while they may have to check that it is on track to pay off the mortgage every five years.
But IMLA said the mortgages would become "effectively obsolete" if the FSA went ahead with all of the proposals.
It added that the introduction of an enhanced affordability test should be sufficient to ensure more robust lending decisions were made on interest-only loans.
Peter Williams, executive director of IMLA, said: "The FSA has set out to create a flexible market that works better for consumers.
"In IMLA's view, its potential treatment of interest-only loans could achieve the very opposite, not least through the increased regulatory burdens and risks the regime will pose for lenders.
"The FSA needs to find a balance in what it proposes so that lenders are still able to offer interest-only loans and thus meet a diverse range of customer needs."
The group's warning echoes one made by the Council of Mortgage Lenders (CML) last month, which also said interest-only mortgages were likely to disappear from the market in the future if the new rules were implemented.
The CML said lenders would not want the extra administrative costs of checking an investment was in place, or the "unmanageable regulatory risk" surrounding the performance of investments that were outside of their control.
Only 17% of mortgages for house purchase were taken out on an interest-only basis during July, down from a peak of 83% in 1988.
Lenders are already beginning to clamp down on the loans, with Lloyds Banking Group announcing last week that it plans to carry out spot checks on brokers to ensure that customers with interest-only mortgages have a way of repaying their loan.
Earlier this year it announced that it would be charging people with interest-only mortgages 0.2% more than those with repayment ones.