Higher levels of pre-payment hit profits

The average age of a mortgage is now just four years compared to seven five years ago. A six-month long study by the Actuarial Profession also revealed how actuarial techniques used in the insurance industry can help mortgage lenders to measure pre-payment behaviour and its impact on profitability.

The study focused on fixed-rate loans, which account for about a third of UK mortgages and which have even shorter lives. It revealed that increased levels of pre-payment occur in the second half of fixed rate loans; when house price inflation is high and housing moves are increasing; when current interest rates diverge from the fixed rate and when pre-payment penalties are set below a certain threshold. It also investigated the adverse effect on lender profitability of higher levels of pre-payment.

The report was complied with the assistance of the CML and data for analysis was provided by eight lenders, including Abbey National, Alliance & Leicester, Bank of Scotland, Barclays, Bradford & Bingley, Bristol & West, Halifax and Nationwide.

The report examines a variety of repayment methods, and suggests that charging borrowers upfront for a pre-payment option, a method that is unknown in the UK at present, may become more common.

It says: “In the UK, lenders typically adjust their funding requirement in expectation of a certain level of unsystematic pre-payment and use pre-payment charges. In recent years, consumer activism, regulatory scrutiny and competitive pressures have combined to make it difficult to eliminate pre-payment risk.”

The report also says that in future lenders are unlikely to recover the full cost of borrowers exercising their pre-payment option. As a result, understanding the drivers of pre-payment behaviour and taking steps to reduce pre-payment rates will become increasingly important to the profitability of fixed-rate mortgage lending.