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The meaning of lifetime

Generating a detailed customer profile is crucial to pricing equity-release products but it must go hand in hand with regular cross- checking of loans throughout their lifetime, says Mortgage Express product development manager Roger Hillier

Equity release mortgages are often seen as complex, arduous products. A typical explanation for this is that their pricing tends to be higher than standard residential and buy-to-let pricing causing many potential clients to fall at the first hurdle. But is this opinion justified and how exactly is an equity release mortgage priced?

One of the key differences between a lifetime mortgage and a five-year buy-to-let or residential fixed rate is that the fixed rate for a lifetime has an open-ended term. This means it is not guaranteed for five years or some other pre-specified period. For the lifetime mortgage, the term could be a few months or more than 40 years, depending on the borrower’s life expectancy, health or propensity to pre-pay. Therefore, the lifetime lender has to make assumptions about the average term of the mortgage which will depend on the customer profile.

The lender then has to make an assumption about the typical term of a lifetime mortgage – this is likely to be somewhere around 15 years. The cost of funding for a typical 15-year mortgage is slightly higher than for, say, a two, three, five or 10 year fixed-rate mortgage. If the loan portfolio fails to behave as expected by the lender – for example, if borrowers live longer – then the lender bears a significant funding risk if money market rates move against them.

This leads us into early redemptions. Lenders typically waive their redemption penalties in the event of the customer’s death or movement into residential care. As most redemptions for lifetime mortgages will be for these reasons, the lender will typically bear an early redemption cost.

Therefore, if the lender has to make funding changes after the loan has completed and money market rates have subsequently moved against the lender, the lender is likely to carry the can.

A key component for lenders when pricing equity release products is profiling the customer. Profiling assumptions determine how and when lenders expect loan balances to be repaid. If the customer is aged 80, for example, the lender can expect loans to typically last 10 years and the loan book as a whole to be completely repaid after 25 years. But if the loan is advanced to a 60-year-old, the lender could expect the loan to typically last 20 years, with a final loan book maturity after 45 years. The lender also has to consider other life expectancy factors such as gender and the single and joint life split.

Currently, lifetime lenders typically offer the same maximum loan to value to customers of the same age whether they are single or the oldest partner in a joint life case, whatever the gender. Over time, this is likely to change.

This profiling work and cross-checking of loans against the lender’s assumptions incurs a cost which has to be covered in the pricing.

The cross-checking starts soon after the loans have completed and throughout their remaining life. Every few years, the lifetime lender has to revisit the loan book and check that the loans are performing as expected. For example, are the loans taken out by 80 years typically being repaid after 10 years? If not, there could be a change in the funding arrangement and a potential funding cost. These subsequent checks and a contingency for the correction in funding are another cost to be considered in lifetime pricing.

Lifetime mortgages bear a significant risk which very few buy-to-let and resid-ential mortgages will face. The risk is that the final property sale proceeds are insufficient to cover the loan balance. Pricing of lifetime mortgages should include provision for the no negative equity guarantee being invoked. The recent Institute of Actuaries equity release working party’s 2005 report suggested that the cost of the NNEG could be in the region of an extra 1 per cent a year on the fixed rate.

A customer can expect a lender with high LTVs for a given age to price more highly than a lender with lower LTVs. This higher pricing covers the greater threat of negative equity.

Lifetime mortgage pricing includes several components not relevant to or less significant than in other fixed rate mortgages.

Lifetime mortgage risks are different – in particular, the NNEG and a non-specific maturity date. An inaccurate pricing policy could result in unacceptable losses on the loans, the consequences of which will impact on the whole market. It is possible the lender could radically change their criteria or, in a more serious scenario, withdraw from the market.

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