Long-term fixed-rate loans: the challenges for lenders
Published: 1 November 2011 | Author: Bernard Clarke
Housing minister Grant Shapps used a recent speech to mortgage lenders to call for an increased flow of long-term fixed-rate mortgages, with terms of up to 30 years, to give borrowers the ability to choose long-term payment certainty on a portable basis.
The CML believes that conceptually Mr Shapps makes a strong point. There are borrowers who are risk-averse and who would be attracted to the payment certainty offered by long-term fixes – as long as they were flexible enough to give borrowers re-assurance that they would not find themselves “trapped”.
The practical problem, though, is the difficulty in designing attractive long-term fixed-rate products that consumers would actually choose above the usual short-term offerings. To be able to provide the comfort of a longer term fix, lenders have to charge a headline rate that typically needs to be significantly higher than the rate on short-term deals, typically more than half a percentage point above shorter-term deals and often much more than this.
This article reviews the previous research we have undertaken on fixed-rate mortgages, considers what has changed since David Miles undertook his review for the previous Labour government, and examines whether and how the long-term fixed-rate “price problem” could be successfully addressed.
The history of long-term fixed rate mortgages
Long-term fixed rate mortgages are not a new concept. Indeed, they have been a matter of interest in the UK mortgage market for decades. Professor David Miles, before he was a member of the Bank of England’s monetary policy committee, was asked by the then chancellor, Gordon Brown, to undertake an extensive review of the potential for long-term fixed rates. He published his report back in 2003. The Treasury subsequently returned to the theme in 2007. And lenders have, over the years, sought to offer longer-term mortgages ranging from 10 to 30 years.
The question of what we mean by “long term” is a matter of debate, though. In the UK, even a five-year fix may be seen as a relatively long-term commitment by consumers, although in the US, Germany or Denmark the phrase “long term” is likely to mean anything between 10 and 30 years.
A key distinction between different types of long-term fixed-rate mortgage is between those with early repayment charges and those without. Long-term fixes in the US typically do not carry early repayment charges, while those in the UK and Germany do. In Denmark, meanwhile, borrowers opting for a long-term fix are often able to choose whether or not to have an early repayment option priced in. This is a consequence of how mortgages are funded.
It should be noted, however, that although US long-term fixed-rate mortgages are prepayable without penalty – that is, borrowers can redeem them without exit charges – typically they are not portable to a new property.
In the UK, mortgages are typically funded by lenders borrowing from retail savers or from the money markets on a comparatively short-term, variable-rate basis. This is not necessarily the case in other countries, where different funding mechanisms exist and are more popular.
How do UK lenders fund fixed-rate mortgages?
Because of the obvious risks in “borrowing short and lending long”, UK lenders offering fixed rates need to ensure that, if they are raising funds on a variable rate basis, they are able to match this with the fixed income of the mortgage loans they have made. To do this, they typically manage the risk of interest rates moving against them and eroding their expected returns by entering into interest rate “swaps”.
This means that the lender swaps its fixed-rate income for variable rate income for the duration of the swap contract (e.g. five years). If interest rates rise, the counterparty will pay the lender in line with the rise while, if interest rates fall, the lender will pay the counterparty. This ensures that the lender’s income rises and falls in line with its variable rate funding. In theory, this means that the lender’s margin on that particular tranche of lending should remain broadly constant.
In addition, UK lenders offering fixed rates need to plan for the possibility of mortgage customers redeeming their mortgages early. Given that the lender enters into fixed-term commitments (either on the underlying funding or on the swaps to ensure that the underlying funding costs are matched to the expected income) there would be costs to the lender in the event that interest rates fall and the mortgage customer decides to leave the mortgage early. The lender would be tied into expensive fixed rate funding, while the corresponding fixed-rate mortgage had been redeemed. This is why early repayment charges usually apply.
The dilemma for UK borrowers, and for lenders, is that the existence of early repayment charges acts as a disincentive to borrowers to enter into long-term fixed-rates. It is possible to offer long-term fixed rates that are free from exit fees, but there is a relatively high premium attached (usually in the form of a higher rate) and there has been no evidence of much appetite for these types of mortgages from UK consumers in the past.
Might the future be different?
It is difficult to see how the UK might, at any time soon, become a market in which long-term fixed-rates become more widespread and more common. This is partly because of the funding mechanisms currently used, and partly because of the cultural aversion apparently embedded in the UK both to the concept of “tying in” for a long period, and to a “price premium” for the benefits of certainty. Without a shift in attitudes towards at least one of these, it is difficult to see what would encourage a move towards a stronger preference for long-term fixed rates.
When the CML last undertook consumer research on attitudes towards long-term fixed rates in 2007, we found that while 37% recognised the peace of mind that long-term fixed rates could bring, which might encourage them to choose one, this was counterbalanced by the fear of losing out if interest rates went down (46%) and an antipathy of being locked in to the same lender for a long time (35%).
Interestingly, given Mr Shapps’ concern that lack of portability might be a feature influencing people’s perceptions of long-term fixed-rate mortgages, this was not seen as a cause for concern among consumers or as something influencing them against long-term fixed rates, at least at that time.
Times change, however, and there is no reason why new creativity in funding or product design should not emerge to make longer-term fixed-rates a more popular and widely available option over time. After all, for a long period prior to the 1990s virtually all UK mortgages were on a fully variable rate basis, whereas the default product for much of the last decade has been the two-year fix, so both consumer appetites and funding mechanisms can and do evolve. The rise of covered bonds in the UK, currently a very young market relative to other sources of funding, may yet give impetus to innovation in the design of future mortgage products.
Horses for courses
In passing, however, it is also worth reflecting on whether the grass is just greener on the other side of the fence. Back in 2004, the then chairman of the US Federal Reserve, Alan Greenspan, said:
“Calculation by market analysts of the ‘option adjusted spread’ on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5% to 1.2%, raising home-owners’ annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many home-owners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.
“American home-owners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful.
“Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge home-owners high fees for protection against rising interest rates and for the right to re-finance. American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.”
These comments may appear somewhat tarnished with the benefit of hindsight, since US sub-prime mortgages were those that typically moved away from the traditional fixed-rate model to the shorter term “adjustable rate” basis. Arguably, it would have been more logical if more conservative lending had been the first type to make this move. The fact remains, however, that building in certainty about payments, let alone flexibility to re-finance on top, carries a hefty price tag.
In short, as far as the UK is concerned, unless and until consumers have a greater desire to choose certainty over price, and lenders can come up with a way of funding and designing a walk-away option that does not carry a significant price premium, long-term fixed-rates are likely to remain a minority product. That does not mean the concept is a bad idea – just that its implementation is far from straightforward.