If you only deal with bridging finance once or twice a year – and many brokers do – some of the principles and practices within it can be a little confusing. The short-term finance sector, after all, is a different beast entirely to conventional term mortgages.
One of the areas where there is often a fair bit of head-scratching is the way short-term lenders charge interest on the loans they offer.
There are three main ways that they do this – on a retained interest, rolled-up interest and serviced interest basis.
I’d say that around 65% of lenders charge interest on a retained basis currently, while 35% roll it up. However, with the FSA’s growing interest in retained interest, expect to see more lenders move away from this calculation method in future.
Most lenders, it’s worth noting, will be happy for borrowers to service the interest on the loan each month as long as the client can demonstrate sufficient income levels.
With loans taken out on a retained interest basis, the borrower isn’t required to make any monthly interest payments.
Instead, at outset, the lender adds all the interest to the balance of the loan and effectively pays the interest itself when it falls due at the end of each month.
So if the client wants to borrow £100,000 for a year then the actual amount he or she has to borrow might be, say, £114,000 – once all fees and interest charges have been factored in.
Another way to look at it is that the borrower is borrowing the interest payments on top of the actual loan.
The controversial aspect of retained interest, and this is where the FSA thinks there may be a problem (more on which below) is the fact that the lender charges interest on top of the interest already added to the loan. So it’s effectively a double whammy.
With loans taken out on a rolled-up interest basis, the borrower once again isn’t required to make any monthly interest payments (often in bridging, you’ll have noticed, borrowers want to be free of any regular payments during the term of the loan).
Instead, and as with retained interest above, the lender rolls up the interest and adds that interest to the balance of the loan at outset.
Where rolled-up interest differs to retained interest is that the lender does not charge interest on the interest already added to the loan.
With both rolled-up and retained interest, note that the loan plus any interest rolled-up cannot exceed the lender’s maximum LTV criteria.
As with mainstream mortgages, this is where the interest that accumulates is paid off on a monthly basis, which means only the loan principal is paid on redemption. Easy enough.
Media interest in interest
In recent months, you may well have seen a fair bit of media interest surrounding ‘retained interest’.
This is because the FSA are concerned that, over the years, this method of calculating interest may not have been explained transparently enough to borrowers – and in a number of cases may even have been deliberately misleading.
Whether or not this is true remains to be seen but expect to see more developments on this front in the weeks and months ahead.
There is every chance some lenders will have to pay redress, which could put many of them under real financial pressure.
Step forward, not step back
Some have argued that the FSA’s sudden interest in, well, interest, has been a set-back for the short-term finance sector.
As I see it, it’s quite the opposite and a step in the right direction. The increased interest of the regulator in the short-term finance sector reflects how much the industry has come on in recent years.
Anyone involved in bridging and the specialist finance sector wants the FSA to be more involved, as this will lead the sector to mature, to become more transparent and encourage everyone in it to get their ducks in order.
That will make for a far more rounded and successful sector in the long term – and create all-important consumer trust.