Counting the cost

Sourcing systems\' total cost tables can be misleading for several reasons and it\'s time this issue was resolved, says Alan Selkirk

The lowest total cost or true cost is usually believed by intermediaries to be the correct way to recommend the cheapest mortgage over a certain number of years.

But the mortgage at the top of most sourcing systems’ total cost tables is not always the one clients regard as the cheapest.

Some of the reasons for misleading total costs I will present here relate only to capital repayment schemes.

MCOB 4.7.13E requires that out of all the mortgage contracts a broker “deems as being appropriate for that customer” they must recommend “the least expensive for the customer, taking into account the pricing elements identified by the customer as being most important to him”.

MCOB 4.7.14G(2) makes it clear that this doesn’t prevent a broker from making a recommendation on other grounds, for example, if speed of service is of the essence to the customer.

But there is still the obligation to choose and be able to demonstrate that the least expensive mortgage was recommended from those that satisfy the suitability criteria for any customer.

The first trap to fall into and risk a serious complaint would be to assume what least expensive means, as this could be different for every customer. But Homebuyer, a compliance and sourcing system, forces a broker to select the meaning of least expensive as chosen by the client.

The main choices, probably in order of most common need, are as follows. First, the request may be for the “cheapest after I’ve paid it off and remortgaged at the end of the special rate/early repayment period”.

This will be the ‘lowest total cost after redemption’, meaning after having repaid the balance outstanding and exit fees.

The balance would be higher if any fee was originally added. Just as important, balances can vary by up to £1,000 from one mortgage to the next after a few years.

Then there’s a request for “cheapest monthly payments”. For example, a mortgage with high fees added to the loan in order to get a lower interest rate.

“Cheapest initial fees or cashback” may refer to where a client is struggling for the deposit amount. And then there’s “cheapest total of upfront costs and monthly payments while I’m still paying the mortgage, and ignoring the balance and exit fees when I redeem it”.

This will be the lowest total cost before redemption (usually until the end of the special rate period). This is provided as total cost or true cost by all sourcing systems, and can be reduced by adding fees to the loan. For example, adding a £599 fee reduces total cost by £599, and then increases it by the minimal extra cost on the repayments.

To see why the current total cost from sourcing systems is often not wanted by clients, you only need to consider a potential complaint.

A client might write to you saying: “You advised me in your letter of January 12 2005 that you recommended Bank of Ireland three-year 5.29% discount since it ‘had a total cost over three years of £402 less than the Alliance & Leicester 4.44% three-year fixed mortgage which you were considering’.

“Since taking out your recommended mortgage I have been advised by another broker that the figures you gave me include the capital repaid each month and that over three years the capital repaid on your recommended mortgage will be £620 less than for the A&L mortgage I was planning to take.

“The other broker explained that after redeeming my mortgage in three years, your recommended mortgage will have cost £218 more than the A&L mortgage – a huge difference from the £402 saving you quoted me.

“I made it clear that I wanted the cheapest mortgage over three years and naturally I meant including interest and fees. The capital I repay is not a cost as I will be getting it back when I remortgage in three years.

“As I consider it is your duty to understand what is meant by cheapest, I am putting in a formal complaint.”

How would you be able to argue against this type of complaint if you received one?

There are no fewer than five reasons why total cost is misleading and why most clients will not want their mortgages chosen on the basis of sourcing systems’ lowest total cost.

First, analyse the balance repayable on repayment schemes at the end of three years. For example, on three-year trackers and discounts, you will find significant differences of as much as £1,000.

This is mainly due to the fact that the lower the interest rate, the faster the capital is repaid in the early years. A 25-year £100,000 mortgage at 5% will pay off £921 less capital than a 4% mortgage over three years. There is a smaller difference in the rate of capital repayment between daily, monthly and annual rest schemes.

So that convincing three-year total cost figure at the top of your league table which is clearly £600 cheaper than its nearest rival could in fact be simply because it has repaid £900 less capital. It is £600 cheaper until redeemed, when it becomes £300 more expensive.

Total cost in the sourcing systems is including these varying amounts of capital repaid as a cost.

Unless a client is fully stretched for affordability they are unlikely to see the amount of capital repaid as a true cost.

Try telling your client: “This has a £100 lower total cost over three years than the next best scheme but it will have repaid £800 less capital. Which would you prefer?”

Total cost from most sourcing systems also ignores exit fees which can vary by up to £250. Again, try telling a client: “This scheme is the lowest total cost over two years and £100 less than the next lowest, although these figures ignore exit fees which can vary by up to £250.”

Some sourcing systems automatically add fees to the loan before calculating total cost if this is the lender’s standard practice. This adding of fees creates the illusion of a significantly lower total cost.

Such schemes jump to the top of total cost league tables. For example, if the fee is £1,500 the total cost is reduced by £1,500 but only increased by the additional monthly payment – say, £150 over two years. A convenient (for the lender) reduction in total cost of £1,350.

Can you imagine saying to a client: “This scheme is the lowest total cost over two years. However, these figures don’t include any fees which some lenders automatically add to the loan but only the small extra interest cost. When you redeem your mortgage the balance will be higher because of the added fee. Is that what you mean by the least expensive?”

With most sourcing systems the effective reduction in total cost from free legal work is ignored, causing free legal work schemes to appear approximately £400 more expensive in the total cost league table than those without this incentive.

Unless you search the top 100 schemes to check for free legals you should be saying to your client: “This scheme is the lowest total cost over two years. But these figures ignore the savings you would make with schemes offering free legal work which can save you around £400.”

The final problem with total costs occurs with large cashbacks.

So is there any value in what has come to be known as total cost or true cost? This is the total cost before redemption, ignoring the varying costs of exit fees and ignoring the varying balances payable.

Total cost before redemption is only valid for clients who have had the difference explained between total cost before and total cost after redemption, and who are mainly concerned about affording the initial fees and monthly payments.

They would also have to confirm that they understand this may mean not having the mortgage which is the lowest total cost after redemption.

Once these two ways of choosing total cost have been explained, a large majority of clients usually want the lowest cost after redemption – in other words after repaying the balance owing and exit fees. Being able to afford the monthly payments and fees is a secondary priority or not a priority at all.

Total cost after redemption is easily calculated by adding the exit fees plus balance owing to total cost before redemption.

For example, for an interest-only loan of £100,000 with a £1,500 fee added, the balance would be £101,500. For capital repayment loans of £100,000 balances after three years might vary between £93,000 and £94,000.

This total is the ‘total amount payable after redemption’ and the initial loan amount could be deducted to give total cost after redemption. But as the initial loan amount is the same for all schemes in the table, the differences in the figures would remain the same.

Only Homebuyer offers total cost after redemption as well as total cost before redemption. I presented the reasons I have given here to it as well as detailed analyses of actual search results, and the company agreed with my arguments.

Total cost over an exact number of years is only a guide. What happens with scheme periods that are not exact? They may have an end date after, say, 21 months or last for unusual periods such as 18 months.

If a scheme has 21 months left until its end date any total cost over two years will include three months at the reversionary rate. But by the time the client applies for a mortgage the end date might have been extended to two years so all 24 payments are at the special rate. The total cost will suddenly drop, perhaps by several hundred pounds.

Are you or the client interested in the total cost over two years of a 21-month scheme? No, you want a comparison with other schemes ignoring the reversionary rate or until the end of the early repayment charge period.

The problem is worse with an 18-month scheme where total cost over two years will include six months at reversionary rate. The scheme will unfairly show a high total cost compared with two-year schemes, yet may be the cheapest option over 18 months.

Which would most clients choose – an 18-month scheme with total cost of £10,000 over 18 months equalling £555 a month, a 21-month scheme with total cost of £11,130 over 21 months equalling £530 a month or a 24-month scheme with total cost of £13,560 over 24 months equalling £565 a month?

They would certainly choose the 21-month scheme if the scheme period wasn’t crucial but how would brokers know it was the cheapest total cost a month? It would almost certainly not have the lowest total cost over two years.

If clients kept on remortgaging to the cheapest total cost per month they would achieve the lowest total cost of all their mortgages combined until their final mortgage was paid off.

I challenge all the sourcing systems to resolve these misleading total costs issues by offering total cost after redemption until end of ERC period, divided by the number of months held. Alternatively, they could give us a ‘total cost ignoring reversionary rate’ so that the distortions with shorter scheme periods are removed.

A 21-month scheme would then be calculated at 24 x monthly payment for a two-year total cost. Or they could give us total costs over specified months as well as years.

I have sent this article to all the major sourcing systems. Homebuyer says it intends to take up the proposal of ‘total cost per month until ERC end date’, while Mortgage Brain invited me to join its focus groups.

Paul Yallop, head of emoneyfacts, responded positively and invited me to a seminar it is hosting at the Council of Mortgage Lenders annual conference entitled ‘Best buys – who should be the winner?’ to debate what should and should not be included in true cost calculations.

Alan Selkirk is an independent financial adviser at Bias-Free Advice

Establishing clients’ priorities impresses them and protects brokers
It is difficult to explain to clients the difference between total cost before and after redemption but you could try following a script such as this:

There are various ways to decide what is meant by the cheapest mortgage so I need to ask you some questions to find out what your top priority is, and also your second priority if you have one.

1) Will you be redeeming the mortgage at a specific time before the end of the term – for example, the end of the special rate period or the early repayment charge period?

If yes, when do you intend to pay off the mortgage or to remortgage? Is it your top priority to have the mortgage with the lowest total cost after you have redeemed it and your balance is repaid? (If yes, go to point 2.) Or is it your top priority to minimise the initial and monthly costs which may well mean you don’t have the cheapest mortgage when you pay off the balance owing and the exit fees? (If yes, go to point 3.) If no, will you keep the mortgage until the end of the term? (The answer should be yes.) Is it your top priority to have the lowest cost of borrowing over the term? This means we can use the APR to judge the lowest cost.

2) Can you confirm it is your top priority to have the lowest total cost after redemption at a definite time when you redeem the mortgage? This is the total of all fees and monthly payments including any exit fees plus the balance of the loan outstanding at that time.

This total cost takes into account varying exit fees as well as differences in balances owing after a number of years on capital repayment mortgages.It also takes into account the increased balance owing because of fees added to a mortgage.

3) Is your top priority being able to afford the mortgage rather than the lowest total cost after redemption? Which of these three costs is the most important for you?

• The lowest initial fees.

• The lowest monthly repayments.

• The lowest total cost of fees and repayments before you redeem your mortgage. This last may not be the lowest total cost after you redeem it and have to pay back the balance and exit fee. This is because any fees added to the mortgage will reduce total cost before redemption but increase it after redemption.

A repayment mortgage may represent the lowest total cost before redemption mainly because it pays back less capital than others in the early years but it is unlikely to be the lowest cost after redemption because the balance owing will be higher than other mortgages. Exit fees vary by £250 and are only added to the total cost after redemption.

Now we have agreed on your top priority, is there a second priority for the cost you would like to be low or the lowest? For example, the initial fees or monthly payments.

A typical example would be a top priority for lowest total cost after redemption with a second priority for low or zero fees.

Obviously, establishing the top priority alone as, say, the highest cashback doesn’t enable a broker to choose the most suitable mortgage. Of those with the highest cashbacks, on what basis does the client want you to select the cheapest?

The top priority and second priorities should be recorded in a fact-find or product confirmation letter. The league table in order of the top priorities regarding cost chosen, should also be kept on file.

This process isn’t just about following the regulator’s rules to the letter and protecting yourself from future complaints. Showing so much interest in a client’s first and second priorities creates a favourable impression that is reinforced when they read it recorded in the fact-find or product confirmation letter. Getting this right means more repeat business and more referrals.

Regulatory requirement should be redefined
Jon O’Brien is director of operations at the Professional Mortgage Packagers Alliance

Regulations state that mortgage advisers are obliged to recommend to customers the product that is least expensive according to the pricing elements that are identified by the customer as being most important to them. This, by any standards, can be seen as ensuring a beneficial outcome for customers and also a deterrent to mortgage advisers who might be inclined to recommend the product that pays the highest proc fee.

The problem with the ‘least expensive’ concept is that the regulator has not given a clear definition of what it means by this term, which leaves it open to interpretation.

This issue is partly covered in Mortgage Conduct of Business where it is acknowledged that, with regard to costs, some customers may feel that overall cost over five years is most important whereas others may be looking for a product that has no early repayment charges.

Also, the requirement to recommend the least expensive product does not prevent advisers from recommending a product on other grounds, for example, taking account of a lender’s speed and quality of service, its lending policies and underwriting stance. It’s no good finding the cheapest deal in the market for a first-time buyer only to discover that the lender providing the product only allows 3 x income and the customer needs 4 x.

At PMPA, all our experienced packager members have built their businesses around helping brokers place cases correctly according to customers’ personal circumstances. Always seeking the cheapest product is not what an experienced packager would consider to be the mainstay of mortgage placement.

A simple adage sums up the approach of the specialist packager distribution sector – place the case correctly first and then seek the correct product. In other words, check with the lender that the circumstances of the case match its lending criteria before sourcing the products.

A classic example of why this procedure is necessary springs to mind. When The Mortgage Corporation was launched it had cheap rates and applications from brokers flooded in but 65% were declined because the customers did not fit criteria.

For brokers and packagers working in the niche and sub-prime sectors, finding a product in which lenders’ criteria match customers’ needs is rather like an old-fashioned tailor measuring a customer for a suit which, when made, will fit only them.

In a market that now covers virtually all niches we don’t often handle cases where only one lender fits an applicant’s circumstances. Whereas prime cases may have plenty of choice regarding the least expensive true cost product, this is seldom the case when it comes to sourcing deals for niche and sub-prime customers.

In a regulatory climate that is moving away from detailed rules and towards principles such as treating customer fairly, I suggest that the least expensive requirement should be redefined as ‘the most competitive to fit the needs of the customer’.

Sourcing systems complement sales process
Bill Safran is chief executive of Trigold

The marketing of mortgage products through sourcing systems has become more sophisticated in recent years.

In an industry as innovative as the UK mortgage market lenders have launched products with many exciting features, benefits and conditions and it has become increasingly challenging to reflect the varying benefits that products offer.

The increased sophistication of sourcing systems has helped determine how well intermediaries can differentiate between the features of mortgage products and drill down to the fundamental economics of products. Sourcing systems now offer a range of tools and filters to analyse products. This sophistication enables advisers to get beneath the marketing veneer and start reviewing products based on facts and figures.

The Trigold system provides filters as soon as the products are displayed so that the universe of products can be narrowed to a manageable number based on a client’s wishes and an adviser’s recommendations. After these filters are applied there are many ways to view and review the remaining options. The initial pay rate is just one of the many display options available for intermediaries to consider.

Advisers typically review the list of potential mortgages using criteria including fees, the monthly payment and cashback amounts. There are a variety of tools at an adviser’s disposal such as total to pay and a remortgage analysis. The total to pay tool gives a broker the ability to review the costs over a specified time period and can include the redemption amount.

This allows advisers to analyse the costs of mortgage products over the expected hold period of their customer, identifying the cost to the customer of any teaser rates and redemption penalties.

Some advisers shy away from looking at a product with a redemption charge that overhangs the time period they have agreed with their client. A total to pay calculator can take this into account and an intermediary may discover that even with this charge payable the overall cost to their client for the period is lower.

This type of tool breaks down some marketing barriers and provides advisers with a way to make a more informed choice. Such tools can also be used to help generate sales and remortgage analyses, and to sidestep inertia from clients. By comparing the overall cost of a client’s existing mortgage with other mortgages in the market, a broker can quantify the benefits of remortgaging. This feature allows a broker to circumvent any marketing pressure that their client may be under, such as avoiding a hefty redemption charge.

A further consideration when it comes to the increasing sophistication of the systems is the amount of detail brokers can enter. For example, the Enhanced Non Conforming module has brought further accuracy to the sourcing of products in the specialist market. In the past, advisers may have been able to flag that there have been County Court judgements or arrears relating to the client but without delving into specifics, this information merely served as a guide to the type of lender rather than a product. With ENC, advisers can enter details including numbers of CCJs, amounts, whether satisfied or not and if so how long ago.

Sourcing systems don’t replace the advice customers get from brokers but they do provide a valuable tool to complement the sales process.