The paper, The demand for long-term mortgage contracts and the role of collateral by professor Lu Liu, found that the pricing of high LTV mortgages seemed to be the most important factor in borrower choice.
Liu said long-term fixed offered protection against future rate changes but borrowers tended to “trade off” their insurance against this risk by choosing to reprice more frequently instead.
The paper looked at data from the Financial Conduct Authority (FCA) comprising residential mortgage originations in the UK and the stock of all outstanding mortgages. Liu also looked at first-time borrower data between 2013 and 2017 to track mortgage choice over time.
Higher cost for low equity borrowers
Liu said: “In simple descriptive analysis, the loan to value ratio plays an important role for fixation length choice. A borrower at 95 per cent LTV is between two to three times less likely than a 70 per cent LTV borrower to take out a five-year fixed-rate contract compared to a two-year contract.”
She suggested this was due to the premium lenders charged on the rate of higher LTVs because of the greater potential loss if the borrower defaults.
The paper said the difference in rate was “sizeable” as the average 95 per cent LTV mortgage was 220 basis points higher than a typical 70 per cent LTV deal over the same period.
Liu said when choosing how long to fix a mortgage, the rate played a larger role for high LTV borrowers, adding: “High LTV borrowers can price in lower levels of LTV over time by repricing via shorter-term contracts with successively lower credit spreads.”
She continued to say that with a standard loan repayment path and expected house price growth of 2.6 per cent each year, the rate of a five-year fixed mortgage at 95 per cent LTV would have to be 69 basis points lower to be equivalent to the corresponding two-year fix.
“Market prices for long-term mortgage contracts are hence relatively expensive for high LTV borrowers,” it added.
Less protection for high LTV borrowers
The paper also proposed that there could be “substantial” gains for high LTV households if they were able to obtain contracts which adjusted for the trend in interest rates.
Liu made a case for “risk-sharing” with high LTV borrowers, similar to the US where longer term fixes of up to 30 years are more common. There the risk is shared through public credit risk guarantees by government-sponsored entities. Liu said any mortgage policy interventions should be done by the state.
She also said this consideration could influence mortgage design and policy debate.
Liu added: “Having high LTV borrowers take out shorter-term fixation lengths may improve pass-through when interest rates decrease, but may be more concerning from a financial stability perspective at a time of rising interest rates, as these high LTV borrowers are less insured against interest rate rises.”
Other factors less of an influence
The paper said it was unclear as to whether borrowers who chose longer term fixes were aware of future market developments, but said there was a trend of households that selected five-year contracts experiencing “somewhat lower local house price growth” and living in regions with less house price volatility.
Overall, it said LTV appeared to be the most important predictor behind the choice of borrowers.
Liu added: “For a borrower with an LTV greater than 80 per cent, a one standard deviation increase in LTV (around 10 percentage points) reduces the probability of choosing a five-year fixed-rate contract by around 18 per cent, or more than half of the average probability of choosing a five-year fixed-rate contract.”
It found that at 70 per cent LTV, the choice was “roughly split” with 58 per cent of borrowers opting for a two-year fix and 42 per cent choosing a five-year term.
At 90-95 per cent LTV, just 18 per cent of borrowers go for a five-year fix. The paper found that a borrower at 95 per cent LTV was two to three times less likely to have a five-year fixed mortgage when compared to a borrower at 70 per cent LTV.
The study also concluded that income growth or the means by which a mortgage was obtained – either direct or through a mortgage broker – did not have an evident influence on the choice of the fixed mortgage term.
