Sub-prime can profit from change

Sub-prime lenders\' flexibility and experience means they are well positioned to cater for clients as base rates rise and the economic climate changes, says Tom Atkins

In the past few weeks there has been a great deal of speculation over the effect that interest rate hikes will have on the mortgage market. Following the rise in August and despite the expectation of further rises to come, the mortgage market has remained surprisingly robust.

The Council of Mortgage Lenders announced that gross lending hit a new record in August, reaching 32.7bn, while the Building Societies Association revealed that net advances were up almost 35% year-on-year.

But while the mortgage market has yet to show signs of a downturn we can’t expect borrowers to ignore the rate rises forever. If, as most analysts expect, a further rise is announced in November the dynamic in the market will inevitably change.

Two issues have come to light in the face of the recent rise in interest rates – the upsurge in popularity of fixed rate deals and the potentially damaging effect of the increase on the sub-prime sector.

With the fear of base rate rises lurking in many home buyers’ minds, fixed rate mortgages have become increasingly popular. Many lenders have already seen borrowers flocking to fixed deals, fearful of future rises.

This trend is un-derstandable. Fixed rates will always be popular when interest rates are rising, with both long and short-term fixes seeming highly attractive at present.

Such products are ideal for individuals on tight budgets or those who appreciate the security that fixed payments offer. These factors are becoming more important as many borrowers – particularly first-time buyers – are being stretched when trying to buy property.

Research from Hay Group shows that more than half of people’s salary is now spent repaying mortgages while data from the Joseph Rowntree Foundation shows that housing costs have risen so sharply for first-time buyers that the ratio of mortgage costs to earnings has reached the peak last recorded in 1990, at 36%.

With many City experts predicting that interest rates will rise to 5.25% next year lenders have been keen to tempt borrowers with their fixed rate offerings. Many lenders have updated their deals while others have introduced products such as 20-year fixes.

While many borrowers welcome the protection that fixed rates offer they should consider their options before committing to a home loan. Research conducted for the Sunday Times reveals that over the longer term, borrowers could be better off with trackers or discounts than with fixed rates. In September 2001, when the base rate was at 4.75% as it is now, someone who borrowed 100,000 using the best two-year discount then switched to another discount every two years was almost 2,000 better off than someone who took a fixed rate.

While fixed rates can save money if the timing is right borrowers should always take advice and consider the alternatives. Borrowers sometimes forget that today’s deals reflect the likelihood that rates will go up in the near future so fixed rates should only be taken after consideration.

It has been suggested that further increases in the base rate will have a particularly strong effect on the sub-prime market. Ratings agency Standard & Poor’s has voiced its concern, having noticed an increasing number of sub-prime borrowers falling into arrears. The CML also predicts re- possession figures will jump from around 10,000 last year to 15,000 this year, largely because of the growth of the sub-prime market.

Undoubtedly a further increase in interest rates will have an impact on the sub-prime market. As interest rates rise, borrowers will inevitably turn to the sub-prime sector as they fail to satisfy high street criteria. While these clients will represent a certain amount of risk, sub-prime specialists are equipped to handle the higher levels of risk whereas mainstream lenders may find it more difficult.

Compared with 18 months ago, intermediaries are doing more business with customers with adverse credit. At the same time there has been a noticeable rise in the number of borrowers with minor credit problems being accepted for prime mortgages.

Sub-prime lenders generally have a more flexible approach to underwriting than those operating in the mainstream.

As increasing numbers of borrowers fail to satisfy standard criteria this may prove to be a huge benefit for the sub-prime sector.

Even with first-time buyer income multiples reaching record levels in July, a huge number of buyers without credit problems are struggling to find mortgages through traditional lenders. Specialists lenders base lending on affordability rather than income multiples and take a more flexible, case-by-case approach. In this way, sub-prime customers are more likely to be offered a product that better suits their needs.

It is estimated that the sub-prime sector accounts for almost 30% of the UK mortgage market and around 90bn of lending each year. Research from Datamonitor backs this up, suggesting that more than nine million people each year struggle to qualify for mainstream loans. While most of these people are likely to be freelance workers, newly self-employed workers or recent divorcees than traditional sub-prime candidates, with increasingly harsh economic conditions more are likely to migrate to the sub-prime zone.

While the sub-prime market may be exposed to greater risks as a result of these changes it will also be in a good position to take advantage of market conditions. The flexibility and attention to detail that are the cornerstones of sub-prime lending will be vital as the shape of the market changes. This is something that both sub-prime and mainstream lenders must bear in mind if they are to continue trading effectively in a changing economic climate.