Below, we share a little more information on the risks that we have to account for, market competitiveness and ensuring a fair and equitable return on investment (ROI).
Pricing for LTV risk
I think everyone is familiar with the concept of pricing for loan to value (LTV), whereby both default probability (PD) and loss severity (LS) increase as you step up the LTV curve. Given both of these increased probabilities, lenders need to hold increased amounts of capital as LTVs increase to cover against potential losses, making higher-LTV loans more expensive to fund.
As can be appreciated, both PD and LS are not linear.
This means that a mortgage at 90 per cent or 95 per cent will require a lender to hold multiple times the amount of capital than, say, a loan at 60 per cent LTV. The probability of a 60 per cent LTV loan defaulting is much lower, but losses, should the worst happen, are also very unlikely.
Mortgage pricing for credit
In the mainstream residential space, the similarities between lenders are much greater than any differences, so credit tends not to be a major factor in pricing variation.
As you step down the credit curve into the specialist space, both LS and PD increase, especially the latter. This is oft reflected in increased capital allocation (if held on a balance sheet) or by rating agency stress (if securitised), resulting in higher rates.
Purchase, remortgage and product transfer pricing
Perhaps less obvious is why lenders often have different prices for the above. There can be multiple reasons for this, which drive lenders to offer differential pricing between these categories:
- Portfolio mix – Purchase and remortgage business does have different characteristics in terms of loan size, weighted average and median LTV. The ‘application to completion’ pull-through ratios also differ between purchase and remortgage business. Lenders, overall, are looking to achieve a good mix of purchase and remortgage business.
- Origination costs – Most remortgage products now come with an array of ‘free’ incentives, be that legal assistance or cashback. All these costs are accounted for in the product. If one product has more incentives than another, don’t be surprised if the rate is higher. With product transfers, lenders do not have the expense of new origination costs, so in many instances can price at or below new origination rates.
- Mortgage performance – A small point, perhaps, especially given the very strong performance of mortgages over the last 10 or so years, but each product category performs slightly differently. For example, with a product transfer, a lender has the advantage of seeing first-hand a customer’s performance, and the original LTV (all else being equal) is likely to have fallen.
Pricing for arrangement fees
The other key determinant in pricing is the arrangement fees. Unlike cashbacks, which are a cost, arrangement fees are treated as an income with the fee having a greater impact over shorter duration products given that the value is spread over the anticipated life of the loan. The other key element is the assumed loan size, with large fee products tending to attract (unsurprisingly) larger loans, and £0 fee products tending to attract smaller loans.
Mortgage pricing for the competition
In a perfect world, there probably would be some kind of pricing symmetry between product categories, but unfortunately that’s not where we live.
The reality is, one or more lenders usually decide they want to be more competitive in, for example, the two-year fixed purchase space, which drives a reaction from competitors. This then creates a disconnect (albeit temporarily) between two-year fixed purchase and remortgage spreads. This happens on a continual and ongoing basis between the different categories and is helping to drive the very low rates we are seeing now.
In summary, we have a very well-established and mature mortgage market that is extremely competitive – probably the most competitive we have seen since 2008. But that’s for another article.
