Why do lenders charge similar rates to much higher risk borrowers?
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Brendan Burgess
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Here is a slide I did for a presentation to the Dublin Economics Workshop in September 2015
Here are the figures for HSBC in the UK
In the UK, where a lender can repossess a house when the borrower defaults, they charge an additional 1% to someone borrowing 90% instead of 60%.
In Ireland, where it's almost impossible to repossess a house, the increase is as low as 0.4%. It makes absolutely no sense.
The 90% rates might be right. The 50% rates are excessive as there is virtually no risk.
Brendan
Here are the figures for HSBC in the UK
In the UK, where a lender can repossess a house when the borrower defaults, they charge an additional 1% to someone borrowing 90% instead of 60%.
In Ireland, where it's almost impossible to repossess a house, the increase is as low as 0.4%. It makes absolutely no sense.
The 90% rates might be right. The 50% rates are excessive as there is virtually no risk.
Brendan
That's very interesting.
It seems like there's not much incentive for the incumbent players to undercut one another. If I'm Johnny BOI, I could cut rates for <60% borrowers, but AIB will follow suit if/when they see their business bleeding. We're back to square one in terms of market share, but now the market is that much less profitable. It's a plague on both our houses. We're better off f̶i̶x̶i̶n̶g̶ matching prices.
On the other hand, if I'm Johnny Pepper or Johnny Deutsche Bank, I have no existing customer base to devalue, and every incentive to cut the legs from under the incumbents.
It seems like there's not much incentive for the incumbent players to undercut one another. If I'm Johnny BOI, I could cut rates for <60% borrowers, but AIB will follow suit if/when they see their business bleeding. We're back to square one in terms of market share, but now the market is that much less profitable. It's a plague on both our houses. We're better off f̶i̶x̶i̶n̶g̶ matching prices.
On the other hand, if I'm Johnny Pepper or Johnny Deutsche Bank, I have no existing customer base to devalue, and every incentive to cut the legs from under the incumbents.
That's the way competition works in any market.
Cui bono?
Customers.
Look at the airline business. What would have happened if Michael O'Leary had simply matched Aer Lingus prices on short-haul flights? Not much. Ryan Air wouldn't have become the biggest low-cost airline in Europe and we would still be paying through the nose to fly to London.
Eventually a lender will grasp the current opportunity in the Irish mortgage market to write mortgages aimed at low-risk borrowers and they will make out like bandits. We should make sure we do nothing to discourage that prospect - we will all benefit from that development in the long run.
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gnf_ireland
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I have also wondered why LTI ratios do not play a role in determining the interest rate charged? Personally I believe interest rates should be calculated on a matrix based on LTI and LTV.
Surely someone borrowing 200k, with an income of 50k is a higher risk than someone borrowing 300k with an income of 100k? They have some headroom to take a salary cut and/or handle unexpected expenses.
*for the record, I believe income should calculated on an applicants P60/Revenue Balancing Statement averaged over the last 3 years*
Surely someone borrowing 200k, with an income of 50k is a higher risk than someone borrowing 300k with an income of 100k? They have some headroom to take a salary cut and/or handle unexpected expenses.
*for the record, I believe income should calculated on an applicants P60/Revenue Balancing Statement averaged over the last 3 years*
Brendan Burgess
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Hi gnf
An interesting point.
I was surprised to see that in Belgium, shorter mortgage terms attract lower interest rates. But I suspect that is indirectly getting at what you are proposing.
I suppose the reason LTV is used is that it is the best predictor of losses. Someone with a high Loan to Income but a low Loan to Value may well default, but the lender won't lose anything as the loan is well secured.
Brendan
An interesting point.
I was surprised to see that in Belgium, shorter mortgage terms attract lower interest rates. But I suspect that is indirectly getting at what you are proposing.
I suppose the reason LTV is used is that it is the best predictor of losses. Someone with a high Loan to Income but a low Loan to Value may well default, but the lender won't lose anything as the loan is well secured.
Brendan
gnf_ireland
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True for losses, once you can secure possession of the property. However, as we know that is not always easy in our current situation
LTI should be a good sign on the customers ability to repay, and how likely they are to end up in default - hence avoiding the whole repossession issue in the first instance.
BTW, I also believe shorter mortgages should attract lower interest rates, as it should signal a higher affordability to pay. That said, I also believe that if someone defaults on one of the 'low risk' products, their risk profile should be reset accordingly.
Gerry Canning
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Could it be they charge similar rates because even the (better) rates are much higher than they should be ie they trouser the extra income!
Shorter term mortgages are always cheaper in the US. From a lender’s perspective, the shorter the term, the lower the risk, because the ability of the borrower to repay the loan is less likely to change. The lender is "on risk" of default for a shorter period of time.
Also, the interest rates on “jumbo” mortgages (mortgages in excess of $417,000 in most US counties) are typically higher. Jumbo mortgages are higher risk from a lender’s perspective because the market value of luxury properties is more volatile so the appraised value of the collateral may not be realised in any foreclosure.
Risk-based pricing/credit scoring is much more sophisticated in the US.
Also, the interest rates on “jumbo” mortgages (mortgages in excess of $417,000 in most US counties) are typically higher. Jumbo mortgages are higher risk from a lender’s perspective because the market value of luxury properties is more volatile so the appraised value of the collateral may not be realised in any foreclosure.
Risk-based pricing/credit scoring is much more sophisticated in the US.
newirishman
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Not that it did them any good if you remember 2008
True, although that was largely down to securitised non-conforming junk that, frankly, bordered on fraud rather than any risk-based pricing model.
We are not big into risk based pricing in Ireland. Historically all banks used a matrix lending rate system. i.e. Standard rate based on type of loan, purpose and duration. Despite the standard matrix becoming outdated we have more or less maintained it as risk based pricing has only caught on here for large Corporate lending.
From historic experience the practice is broadly similar in the UK but I have no idea how pricing works in Continental Europe!
From historic experience the practice is broadly similar in the UK but I have no idea how pricing works in Continental Europe!
The credit market is different to the flights market in some significant ways:
- From a consumer perspective, moving a mortgage is much more difficult than changing airlines.
- From a business perspective, it's much easier for a competing bank to change interest rates than for an competing airline to retool for a low-cost model.
If I drop my interest rate today, the bank across the road can drop it tomorrow, before I've gained any new customers. Banks' cost-of-credit are all pretty much identical here, right?
If i were to announce €5 flights to Berlin today, Ryanair would need years to get their supply-side costs low enough to match me (lease a new fleet, secure cheaper fuel and landing prices, and renegotiate salaries).
Keeping the status quo - where each incumbent owns a slice of a "fat" market with lots of profit margin may be preferable (from their perspective) than owning 100% of a lean market.