Nine years ago Norwich Union was in a position which many today would be enviable of. It was the only well known provider at the time offering what is now known as a lifetime mortgage. The charging structure of the product looked very different to how it looks today. Since then product development has been extensive, with many providers having created a range of options which are a far cry from the more static plans of old.
Red herrings
Product development may well provide the opportunity for lenders to capture sectors of the lifetime mortgage market, however, it can also be an opportunity for potential red herrings to creep into our analysis, which complicates the advice process. This red herring aspect is one that historically, with less flexibility and competition, providers have not had space for, though today it is easy to latch onto product features which steer client decisions which are not based on realistic priorities.
The red herrings typically are the features which may be perceived as ‘nice to haves’ but which, given the consequences, a client would not otherwise want or require – the main consequence ultimately being a considerable effect on the cost of borrowing. Why this is such an important factor, particularly in this sector, is that product pricing is crucial when looking at roll-up interest plans. A 0.5 per cent rate difference can cost many thousands. If the recommended option was based on a red herring as a priority, this could well leave the suitability of advice up for question.
What makes life even more difficult for advisers is that, unfortunately for some, the options which we perceive as possible red herrings may well prove to be real priorities, which means that, ultimately, they still must be explored but in the correct context, i.e. the bigger picture. A client needs to be armed with the knowledge that a potential ‘nice to have’ may have greater consequences in the overall scheme of things.
Early repayment penalties
One which causes much controversy among advisers is the issue of early repayment charges (ERCs). ERCs range from zero up to potentially as high as 25 per cent of the amount borrowed, so naturally it is important that it is established whether an early repayment option is a priority. This can come in one of two forms – the client who knows they are going to or may repay early and those who have no intention or potential ability to repay early. On the face of it, today’s products do not offer options other than the minimum of a five-year ERC period and up to 5 per cent which is offered by a number of providers, including Mortgage Express. Northern Rock offers no ERC for loans below £25,001 whatsoever. Its cash plus scheme also comes completely ERC-free so there are options available.
Interestingly though, the ‘no ERC’ or ‘low ERC’ options are typically far from the top of the table when it comes to interest rates and for this reason early repayment as a priority needs to be fully explored, either to identify or exclude it as a priority. The third consideration is the customer’s desire to have the flexibility to repay early to remortgage should better deals be available in the future. Many clients may opt for this, but it needs to be documented that to have this option again will mean they will probably be paying a higher rate now and there is no guarantee that there will be better interest rates available in the future.
It is very easy to sell products with low or no ERCs if we want to, but are we helping the client if it is not a real priority? The client who has the option to repay early should either have the funds to repay or will have, for example, selling up and downsizing in three years time, or it needs to be documented that they are doing so for the option to remortgage. Without the documentary evidence, we may well have created a red herring sale.
Protection
Another potential red herring with lifetime mortgages is the protected option. Firstly, one thing to point out is that this option, as with options to repay early, are totally viable. That said, it can be very easy to sell the benefits when it will never potentially be of benefit to the client.
The protected option which is offered by Northern Rock and Stonehaven allows the borrower to protect a proportion of the property value as a percentage. The total amount repaid cannot take any part of the protected portion, for example, if the client has a property value of £200,000 and they want to protect 25 per cent, then the maximum that the lender can have on redemption is 75 per cent of the value. In principle this can be of considerable benefit to the client for who inheritance is a priority. This comes at a price though, due to the fact that the lenders offering these plans do not feature at the top of the rate table, and that is why this can be a red herring for clients for whom this is not a major concern or who are borrowing lower amounts.
Looking at examples
It is useful to see an example of when it may be unwise or of no benefit to add this option. A client aged 65 who is living in a property worth £250,000 wants to raise £25,000. This amount can be raised from a provider offering the protected option or not. The non-protected interest rate annually is 6.45 per cent from National Counties and the protected rate is 7.97 per cent from Northern Rock. The client is able to protect 50 per cent of the property value with Northern Rock based on their age, loan amount and property value. The first table on the opposite page shows the effect of the interest roll-up and the second table depicts the equity remaining against property price fluctuations.
What this shows is that the protected option in this example, due to the differential in interest rates, is only the better option if the property value were to fall by over 1 per cent each year. More importantly though, if property values were not to fall by more than 1 per cent, stay the same, or increase, the overall inheritance will always be less. The real message behind this is that the protection is just that.It is a protection, in this example certainly, against property values falling. This, of course, should not be ignored as the worst could indeed happen. However, an informed decision can be made when the cost of having such a benefit is seen.
This brings us back to the point of whether this is a priority for the client or not. If not, it can be a very costly ‘nice to have’ – if the property value stayed the same or increased, the cost of the protection would amount to £28,611, a considerable loss of inheritance.
What the scenarios show is that all options are viable but the answer lies in whether we are advising clients based on priority or on ‘nice to haves’ without fully exploring the consequences.
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