Mortgage lending unsecured in all but name – interest rates no longer reflect risk!
Over the course of the last few years, a debate surrounding the cost of mortgages here in Ireland suggested something might be wrong. A central tenant to the argument was a comparison of the cost of mortgages in other Euro countries; mortgage costs were deemed to be high in Ireland simply because they were lower elsewhere.
Mortgage rates are the result of a complex set of factors, not just the cost of money.
Those interest rates reflect three primary risk factors; income, credit and security.
The third of those three risks, security is what ultimately mitigates the complex risk factors that mortgages present to all lenders. Without it, interest rates would be far higher.
But over the last few years, some disturbing statistics have come to light that threaten to undermine the core principles of underwriting and assessing mortgage risk.
Take mortgage arrears. There are still over 50,000 mortgage holders in arrears of 90 days or more. In fact, Ireland has one of the highest rates of long-term arrears across the EU but on the back of that, it has one of the lowest rates of foreclosure.
Nothing wrong with a society working to ensure those in financial difficulty do not lose their homes.
But here, it seems something is amiss.
Mortgages by their nature are complex ‘secured’ loans. In other words, the guarantee of repayment of the debt is secured by the property; if the borrower is unable to repay the loan in the future, the lender has the right to sell the property in order to settle the outstanding debt. This right is granted by the borrower to the lender by way of the mortgage contract.
When the lender assesses the borrower if they are ‘qualified’ for a mortgage, a whole range of risk factors are taken into account. Broadly, those boil down to credit, income and equity security.
But the first two risk factors, income and credit are short-term in nature. They only provide the lender with a few short years of earnings history and credit history. Neither can offer the lender any guarantee the applicant will continue to be employed, or earn the same income or enjoy the same level of income in the future as they might have when they applied for a mortgage. The same goes for credit history, this can change if the applicant loses a job, becomes ill or suffers a marriage breakdown.
It is only the third pillar, the property security that offers the most reliable protection for any lender into the future (yes, prices can and do fluctuate but prices are again increasing here in Ireland).
But, the mortgage risk premise here in Ireland is flawed.
For a start, it is extremely unlikely that lenders will take possession of a property where the borrower has not made repayments for a prolonged period of time. This makes mortgage lending ‘unsecured’ in all but name.
Unsecured lending is typically far more expensive that secured lending.
To compare costs, even where we take some other forms of secured loans here in Ireland, car finance loans offer a good example. Many are offered to consumers at rates of 3% – 4%
Unsecured loans on the other hand include personal loans and credit card debt. Both cost anywhere from 8% – 18%, or more!
But mortgage lenders currently offer loans to home buyers at interest rates of about 3%. This is very cheap finance for loans that are largely unsecured in nature. So, what are lenders to do?
Broadly, lenders can price for risk individually or collectively. On an individual basis, this would focus on borrower losing their right to the property the mortgage was granted against if they are unable to make payments for a prolonged period of time. The second alternative is the risk is priced collectively, where all borrowers pay higher mortgage costs from inception.
Of course, the third alternative is for mortgage lenders to restrict mortgage lending altogether and they could do this a number of ways:
- Restrict the lending categories, focusing on employment types that offer elevated levels of employment security, including those working for the State.
- Restrict the loan-to-value ratios – this would have a significant socio-economic impact with only those with high savings potential, wealthy family backgrounds or some putting off buying into later in their careers.
- Restrict loan terms – this would result in a sharp rise in monthly loan repayments for borrowers and would restrict lower income borrowers from gaining mortgage approval.
Mortgage costs are typically priced on the basis of the property acting as the main security backstop. As this continues to be largely unused here in Ireland, it could pre-empt a new mortgage model, one that is more selective in those that qualify and in cost to those that do.