CML Housing Finance Issue 062007 September 2007
Mortgages - informing customer choice
The Annual Percentage Rate (APR) is currently the standard measure for comparing the costs of loans, and one that must be disclosed to borrowers. A key assumption that underpins the APR calculation is that loans will be held until maturity. But, in today's intensely competitive market, most mortgages are repaid after just a few years, and this means that APR information can often be irrelevant or confusing. This paper proposes a new interest rate measure - the Dynamic Annual Rate (DAR) – that presents cost information across a wide range of different mortgage products in a simple and effective way.
The DAR differs from the APR in two key respects: it is calculated for any period of time for which the loan may be kept (rather than only the full term as in the APR); and it takes into account all payments and charges, including any early repayment charge and exit fee, over the period for which the mortgage is held. DARs contain a lot of information, and can be used to show how the true cost of a mortgage varies over time.
They allow straightforward cost comparisons between mortgage products over any period that a borrower is likely to hold them for. The DAR approach could also help borrowers better understand how future changes in interest rates would affect the costs associated with different mortgage products and when product switching would be worthwhile. DARs offer several potential advantages over the APR, and may help advisers satisfy their Treating Customers Fairly requirements by providing information to borrowers that is easily understood, clear, fair and not misleading.
A new measure of mortgage value
The market for domestic mortgages is highly competitive. A large number of lenders offer a vast range of products, including fixed-rate, initial discount, tracker and cashback mortgages. And within these groupings, there are further significant variations in such things as interest rates, set-up charges, cashback or introductory discount incentives and early redemption charges.
Authors Frank Chacko Consulting Actuary, Grant Thornton Editor Bob Pannell Head of Research, CML
In theory, such choice provides the opportunity for borrowers to select the most suitable product for their needs. However, increasing product complexity means consumers often have a poor understanding of the mortgage product they purchase despite the wealth of information given to them. In particular, it is arguable whether or not borrowers are able to make an informed choice as regards to comparative value.
Under the Financial Services Authority's (FSA) Principle 6 for businesses, all regulated firms including mortgage advisers, are required to 'treat customers fairly' (TCF). Whether or not customers understand the product, the obligation is on advisers to communicate costs clearly and fairly. Firms are also obliged to ensure that any advice provided to their customers is suitable. Closely aligned to this obligation is Principle 7, which requires firms to provide information to their clients in a way which is clear, fair and not misleading. It is not clear how the obligations under TCF (that require firms to communicate price information in a way that is clear, fair and not misleading) can best be met by using the tools currently prescribed. The measure that supposedly helps with the comparison of mortgage costs is the Annual Percentage Rate, or APR.
But the APR is of limited value for mortgage comparison purposes because most loans typically last for less than five years. In this article, we present a new approach to presenting mortgage cost information - the Dynamic Annual Rate. The approach offers a simple and effective way to evaluate the true cost of a mortgage, how costs vary over time, and how they compare with other mortgages. First, though, we consider the APR and its shortcomings. Problems with the APR The APR historically arose from the need to compare costs on hire purchase and other short term loans. It effectively produced an average rate of interest over the full period of a loan, so allowing consumers to compare in advance the relative costs of loans which had differing interest rates, fees and other charges.
The formula specifically excluded allowance for default charges and, by implication, the fees payable on early redemption, because it assumed borrowers kept the agreement and held it for the full term. A simple example of the APR may be useful. For a four year loan where 4% applies for the first two years and 6% applies for the second two years, the APR would be roughly 5% per annum, reflecting the average rate of interest applying over the four year period of the loan.
The same principles apply if the loan carries initial charges - we calculate an average rate of interest which treats the initial charges as an addition to the interest rate spread over the full term. For short term loans, the APR works well and represents a very helpful standard measure. It is a simple measure; it is relevant since the majority of such loans are held for the full term; it provides a valid measure for comparing different loan costs. Furthermore, its extension for long-term products such as mortgages was reasonable when mortgages were generally held for long periods.
Mortgages - informing customer choice
However, over the last thirty years mortgage products have changed considerably and today are far more complex than they were in the 1970s. Consumer behaviour and the role of intermediaries have also changed significantly, with far greater emphasis on product switching and value for money considerations. In recent years, around half of all mortgage sales have been remortgages. Therefore, even though the majority of mortgages are taken out with original maturities of 25 or more years, they are often kept for just a few years. Over time, the APR formula has remained fundamentally the same, despite its underlying assumptions not remaining entirely valid in the environment of more complex products and very different consumer behaviour.
The main issue that arises is whether a measure that provides the average rate of interest over the full period of a mortgage, say 25 years, is useful when mortgages today last for far less time. Furthermore, because of the short period for which many mortgages are held, the early repayment charge (ERC) is a significant item of cost for many borrowers, but it is not an item that features in the APR formula (by definition). As a result, the APR – a piece of information that must be disclosed to borrowers – measures costs over a time period that is irrelevant for the vast majority of borrowers. It is this aspect which lies at the heart of the problem: the average rate of interest charged over the period most mortgages are typically held, such as four or five years, generally bears little relation to the APR calculated over 25 years
A new approach - the Dynamic Annual Rate
The new approach proposed in this article is similar in some ways to the APR, but differs in important respects. First, instead of forcing the term used in our calculation to be fixed as the maturity term of the mortgage, it is calculated for any time period up to the mortgage term. Secondly, allowance is made for all the charges and payments relevant for the period, including the early repayment charge. As a result, the equivalent average annual interest rate can be illustrated over the range of time periods for which a mortgage is likely to be held – we call this the Dynamic Annual Rate (DAR). The DAR, therefore, is a continuous measure that can be read off for any time period the consumer thinks they may keep the mortgage for.
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