Interest rates pricing models – why proximity is narrowing

An increasing number of lenders are offering mortgage products for five-year fixes and two-year fixes at similar rates.

This rise in the demand of five-year fixed rates, and their pricing proximity to two-year fixed rates, Buster Tolfree (pictured), director of mortgages at United Trust Bank, said can be relatively easily explained – pointing toward affordability and cost of funds.

Affordability and cost of funds

From an affordability perspective, Tolfree said lenders and banks do not need to apply an interest rate buffer, usually referred to as the stress-test, on products that are fixed for five years or more.

“The logic for this is that when a product is fixed for less than five years, it represents a more responsible lending decision to include an assumption that interest rates will rise beyond the initial or reversionary rate stated at origination, and so applying a stress-test to that rate will prevent borrowers entering financial difficulty in the future,” he said.

While different firms have different views on the level of stress-test they may apply, relevant to their own credit appetites, Tolfree said, typically these range from 1% to 3%.

The Financial Policy Committee (FPC) at the Bank of England historically recommended a minimum 3% stress-test be applied to products fixed for less than five years, unless a lender could justify a different percentage based on its own experience - but after consulting with the industry in February 2022, Tolfree said this stress-test requirement was subsequently removed in August that year.

“The justification for this decision being that the FPC felt the loan-to-income (LTI) flow-limit restriction on the amount of mortgages any lender can advance with an LTI over 4.5 was sufficient to protect consumers against household indebtedness,” he said.

Tolfree added that, generally, the industry agreed, as 27 firms, including the four major trade bodies who represent the mortgage industry, all supported the proposal.

“The timing may have left a little to be desired, falling only one month before the debacle that was the September mini budget, but the FPC were not aware of the impending Truss-Kwarteng grenade that proved so costly to the UK economy, as this work started months before,” Tolfree said.

Most lenders have retained some sort of stress-test, as Tolfree said it is generally accepted as good practice, but it no longer follows strict rules as it did in the past.

“This leads nicely into the second factor that has caused the tightening of the pricing difference between two- and five-year fixed rates; a material change in the cost of funds,” Tolfree said.

The September mini budget last year, Tolfree said, threw the financial and capital markets into a whirlwind of uncertainty. He said this caused the swap market, the basis on which many lenders then derive pricing, to view short term money as higher risk than longer term money.

In turn, Tolfree added that this inverted the established swap curve, where longer term money was priced higher than shorter term money.

“As of May, 15, 2023, two-year swaps are at 4.6% and five-year deals are at 4.1%; this tells us that the capital markets still see greater uncertainty on the short term horizon, than in the longer term,” Tolfree said. As a result, capital market, or warehouse line, funded lenders,  Tolfree said, started pricing two-year fixed rates higher than five-year fixed rates.

Banks and building societies, who are funded differently through customer deposits and swaps, Tolfree said, are not necessarily as heavily effected due to their more diversified funding options, but added that ‘market dynamics are market dynamics.’

“Personally, I would expect to see normalisation in the swap curve, and a return to previous trends once the economic uncertainty begins to abide, however, this could take some time based upon inflation, and the 12 straight base rate rises we have had,” Tolfree said.

Impact on the mortgage market

Tolfree said UK Finance and Land Registry are both stating that 2023 will see around a 20% to 25% reduction in mortgage transactions. This, combined with a trend towards longer term fixed rates, means that it is extremely likely there will be materially less new customers in the market seeking a mortgage in 2023.

“This is obviously going to have impacts on both brokers and lenders, however, hopefully firms have squirrelled away some of the income from bumper years in 2021 and 2022 to help them through what is likely to be a tougher 2023-24 than any of us would have liked,” Tolfree said.

One factor that does not seem to be getting much attention as a by-product of the rising interest rate environment and increases in cost-of-living, Tolfree said, is product transfers (PTs). Most lenders offer PTs, either direct and or through brokers, and Tolfree said a well-known mortgage club recently told him that a third of all their 2023 transactions are PTs, up from a sixth a couple of years ago.

Tolfree said PTs give consumers certainty of a new rate with their existing lender, usually without having to go through a full application process, and thereby avoid a new valuation and proof of income.

However, he said one emerging risk is that because there is limited affordability assessment, beyond being up-to-date with your mortgage at the time the PT takes place, a new affordability risk is introduced.

“Take me as an example, the Tolfree family’s current mortgage ends in August and is at 2.09%, the new five-year PT being offered by my existing lender was 5.15%; I could take this rate with three clicks in the lenders app,” Tolfree said.

Now, while Tolfree said he could have done that, he instead ended up remortgaging to a new lender at 3.84%.

“However, many of the general public are falling through the gap of not being able to prove affordability to switch lenders, so just defaulting to a PT with their current lender, with a limited, or no, affordability assessment,” Tolfree said.

Why do you believe pricing proximity of two- and five-year fixed rates is narrowing? Let us know in the comment section below.