The world of mortgage pricing could seem to some as shrouded in mystery, wrapped in a mystical world of macroeconomics and higher maths. In truth, pricing mortgages is like pricing most things: you cost the components, respond to market dynamics and devise a product you hope will be attractive and financially beneficial to all concerned.
Mortgage brokers aim to satisfy the needs of potential borrowers who seek expert help, advice and guidance through the stages of the largest financial purchase they are likely to make. Many might wonder what influences the construction of a mortgage and how are they priced.
There are many factors that combine to influence the features and specification of mortgage products. They cover a number of areas, all of which are inter-related.
The issues considered by lenders range from general world and country-specific economic conditions; the cost and methods of raising funds; risk and return analysis; and competition. These are the main drivers under consideration when lenders look to piece mortgage products together and decide on the price at which they will be made available.
A better service
Awareness of such factors should help mortgage brokers attain a better understanding of the mortgage market in general and enable them to provide an even better service to clients.
To the old certainties in life, death and taxes should be added the pivotal role played by rising and falling interest rates. Interest rates affect the prices of everything (not just borrowing money) and are instrumental in the pricing of mortgage products. Rates do not act in isolation, however, and the key influences of competition and risk taking will also be crucial for the pricing decisions (once made) to succeed in any local mortgage market.
Traditionally the UK market has been based upon short-term interest rate indices and these include the bank base rate, standard variable rate (SVR) and Libor. These often change and are driven by factors such as Government economic policies and inflation levels. But products based on short-term interest rates do tend to allow the market to offer lots of feature-led mortgage deals which borrowers can swap and change according to their priorities.
By contrast in the US, borrowers tend to have long-term fixed rates for the duration of the mortgage, which can be up to 30 years. These types of mortgage are funded by lenders making longer-term purchasing of funds, which tend to be more expensive, compared to short-term rate levels used in the UK. The beauty of this situation is that the US borrower will know the rate they have to pay for the life of the mortgage, thereby giving them total transparency. The downside is the mortgages tend to be more expensive when compared to products, with the benefit of historically low UK mortgage rates.
When we turn to the subject of competition and its impact on pricing, it essentially comes down to the margin to be made on a product. Any lender looking to put a product together and decide on its specific features, be they fixed, discounted or capped and at what interest rate, will do so with one eye firmly upon the effect on the margin it can make.
No lender wants to produce a mortgage from which they can make no money ‘ or that is not attractive to borrowers. But in the interests of market dynamics, decisions often need to be taken to shave the margin and deliver a loss leading, low-cost, short-term fixed or discounted rate to attract or ‘buy’ market share. Ultimately, the margin is sacrificed for a period to achieve the sale. It is a case of calculating how long to keep the special term running: at some point the product will need to turn into a profitable one.
How low can you go?
In terms of how far a lender would go in shaving the margin is up to individual lenders. But profitability on a loss leader product is difficult to achieve and in such cases, relying upon the existing book rather than a new mortgage book to drive income into the business may be the option to follow.
Risk analysis also plays a major part in product pricing, particularly in the niche areas of the mortgage market. Any lender developing sub-prime, buy-to-let or self-cert products requires a clear understanding of their typical borrower. Once this knowledge has been attained, lenders will price the product to reflect the increased level of risk.
As in all forms of financial lending, a careful assessment has to be made of the risks involved and mortgage lending is no different to a car or household insurance. The ‘bad’ or riskier driver will always pay a higher premium than a ‘good’ driver and the same laws apply when considering a borrower.
Whether it is the credit profile of the borrower, or the purpose of the loan, the price charged for the mortgage needs to reflect the ‘risk’ element and it is up to individual lenders to assess that risk and price accordingly, while keeping an eye on the competition. That is why it is imperative for niche-led lenders to have expert underwriters to assess, on an individual basis, the particular factors and profile of borrowers that niche lending can attract.
Such expertise and a policy of pricing for risk should ensure the lender is protected in the majority of the lending decisions it has to make.
When it comes to lenders’ funding techniques, banks and building societies have, in the past, relied on retail deposits to fund their mortgage lending requirements. But in recent times there has been the rise of the financially-aware consumer, who wants their money to work harder and is not content to see their cash sitting idly in a deposit account. As a consequence of consumer power, the ability of banks and building societies to use their retail deposit funds, as they have in the past, has been squeezed.
The market is now seeing a number of banks and building societies securitising their mortgage assets. This results in a more ‘equal’ cost of funds to lenders across the market. In time this change will result in more expensive mortgages across the board as access to the cheapest route to funds dries up. This is a sea-change underlying the UK market and is one that, as yet, has received very little comment.
In terms of deciding how to construct a product, the product specifics will largely be driven by competition. However, lenders will also assess where they think the economy stands within the overall interest rate cycle. One only has to look at the cyclical nature of bank base interest rate levels over the past 30 years to see this will always be the case. We have seen the peaks of the 1970s, early and late 1980s with base rates as high as 17%, as well as the current situation with rates at a 40-year low.
Using the option of ‘hedging’ or ‘swapping’ the lending funds with another financial institution, lenders can spread the risk of fund purchase. A lender offering a capped product in a rising rate climate could swap the capped assets into Libor-based funds. The lender will pay a fee for the swap ‘ but will enjoy protection should the rate change. Conversely, offering a fixed rate mortgage in a falling rate environment might not require hedging and with it no additional costs ‘ but this is a riskier proposition.
In the UK this works well as lenders can choose what interest rate index they like to be based upon, such as bank base or Libor. In addition, those lenders operating an SVR have the option to vary it as they choose, because it is not tied into an index. This contrasts with the US, where lenders can choose from a number of indices, but the decision to move tends to be driven by the market, rather than the lender itself.
On the back of historically-low interest rates, the UK consumer has benefited from cheaper mortgages for some time. UK lenders relying upon short-term indices have been able to devise and create mortgages that reflect these low interest rates, as they have the flexibility to do so. The current unprecedented level of mortgage business is testimony to the fact that current pricing is attractive, affordable and right for the current economic climate. As in all markets, anything should, in theory, be priced correctly and when products are over or incorrectly priced, a break in the market will occur. This break will result in a correction as the market reassesses itself before starting again.
From a potent combination of consumer habit to market competition, the influence of interest rates and the lender’s ability to protect itself ‘ from borrower risk analysis to product innovation and profitability ‘ many factors play a part in the pricing of mortgages. Lenders must keep a close watch on these factors at all times. If they fall into the right place at the right time, it will result in a popular product that benefits everyone ‘ the borrower, the mortgage broker and the mortgage lender alike.
Bill Cherry is managing director of Southern Pacific Mortgages Ltd
While economic conditions are key to the overall pricing of mortgages, competition often determines specific product features.
A UK mortgage will be priced around bank base rate, standard variable rate or Libor.
UK lenders rely on short term indices which provides them with the flexibility to price products around current low interest rates.