Lenders adopt a variety of models when determining rates, but which is likely to be the most effective for customers?
Understanding the great variations in risk is one of the reasons working in short-term finance is so enjoyable. Each loan is different, representing a unique credit risk profile. So what is the fairest way to apply interest rates?
Fixed based on LTV
The most widely adopted method of calculating interest rates is based on loan-to-value. A lender will determine LTV brackets and each will attract a different rate.
Interest rates rise as LTV increases, typically in 5 to 10 per cent increments.
Rates for semi-commercial, commercial and land with or without planning will often be more expensive than residential at commensurate LTV, and maximum LTV will be lower. The advantage of this system is transparency and ease of use. The disadvantage is the treatment of borrowers who suffer from ‘near-miss’. This occurs when they fail to qualify for a pricing bracket, often because of the value being lower than estimated. The smaller the margin of miss, the larger the impact.
For example, if a borrower missed a 70 per cent product by 3 per cent and the property value was £100,000, they would miss by £3,000. Some would be able to meet this from savings and continue on the reduced rate, but where the amount to cure is higher or the borrower does not have capital available, they could be subject to higher pricing, not only on the additional borrowing of £3,000 but on total debt.
If the price increase was a rate loading of 10 basis points per month and the term 12 months, this would create an additional cost of £876, or 29.2 per cent per annum, on the additional £3,000.
Fixed rate for all LTVs
Here, interest rates are priced at a fixed level for all lending, regardless of property type and LTV, so long as this does not exceed a maximum level – typically 70 per cent. This model may create some pricing difficulties, as higher LTV cases where a higher risk profile exists may need to be declined or repriced, leading to frustrations for consumers or intermediaries.
That said, given the challenges when pricing interest in relation to fixed LTV brackets, it provides some relief, as rates will not move despite the LTV being higher than originally estimated. Where a borrower requires 65 per cent lending, they potentially have a 5 per cent margin of error in valuation, so are less likely to be affected by interest rate inflation.
Dual pricing incentivises customers to redeem within the reduced interest period before rates rise. Initial rates are often very attractive, before increasing to a significantly higher level, sometimes double. This form of pricing has merits.
Borrowers with a robust and reliable timeframe for redemption can benefit from lower pricing. But they are exposed to the risk that pricing will rise, perhaps to a greater amount, should this not occur.
Dynamic or risk-based
Here, each loan is underwritten and a bespoke interest rate applied, based on underlying risk and market dynamics. LTV plays a central role but other areas such as experience, location, exit strategy, tenant or lease covenant, extent of refurbishment, asset and liability, income, and credit profile are considered.
This model makes most sense to me, and I understand it has worked well within the second-charge market. This method was born from a need for lending to be priced in a way that was more representative of how the bridging market operated; interest rates are negotiated, not fixed within a product matrix.
Lenders need to be more flexible and pragmatic. Dynamic or risk-based pricing is largely ubiquitous – the only difference is whether lenders are open or discrete about promoting the method. It could be further improved by adopting the key positive of fixed rate for all LTVs – borrowing headroom.
Borrowers would be quoted an interest rate for the desired LTV but then a maximum LTV is provided for this price. For example, a borrower may require 60 per cent LTV but the price would be guaranteed to 65 per cent, thus avoiding the near-miss issue.
Chris Fairfax is managing director of Catalyst Property Finance