Prior to the introduction of Mortgage Credit Directive (MCD) on 21 March 2016, second charge secured loans were regulated as consumer credit and governed by the Office of Fair Trading (OFT).
The outcome of a lengthy and broad consultation by the Financial Conduct Authority (FCA), commencing in September 2014, confirmed that intermediaries, lenders and trade associations largely supported a new regulator and regulatory framework to replace archaic consumer credit law and an ineffective OFT.
The Consumer Credit Act 1974 and 2006, which provided regulatory policy for secured loans, introduced some consumer protections, but was also inadvertently responsible for the creation of increased intermediation and inflated fees. MCD has improved the second charge mortgage industry, but completion numbers are lower despite substantial reductions in interest rates.
FCA regulation of 'seconds' has changed the market, with both current and future relevance.
Being involved in the distribution of secured loans from the mid-1990s to 2006 was a license to print money. For much of this period it remained unregulated with ubiquitous self-certification of income, 125 per cent loan-to-value and commissions circa 10 per cent plus high percentage broker fees. Many multi-millionaires were created.
Distribution in this period was controlled by “packagers”, so called for being a conduit between lender, broker and borrower; responsible for issuing loan documents, obtaining proof of income and instructing valuations – basically organising a full file for submission to a lender so they could review it internally and complete an application.
The advantage for lenders was being in control of operational costs in a market that had historically grown and contracted dramatically as a result of recession and subsequent property booms. In most cases a customer experience would involve applying for remortgage and being told they either “did not qualify” or that a secured loan was a better option for a number of reasons.
Their mortgage broker, however, was unable to apply directly to a secured loan lender as distribution was limited to a small panel of packagers, at its peak perhaps 30 to 40 companies nationally.
Consumer credit law was responsible for creating the packager. The Consumer Credit Act did not allow for intermediaries or lenders to charge proposed borrowers any upfront fees – this extends to application fees in addition to advice fees.
Therefore, borrowers were unable to pay for valuation fees, third party reference costs, lender fees, or broker fees. Valuation and third party fees such as consent to a second charge must be paid upfront as both surveyor and first charge mortgagee require payment prior to completion.
As a result, substantial upfront fees were required to be paid, and borrowers were restricted by law from picking up the bill. Conflicted lenders found it difficult to determine what borrower estimates of property value were accurate and were exposed to potential loss should the estimate prove to be too high.
Mortgage brokers were used to dealing with first charge lending where a client either received a free valuation or could pay upon application and had no desire to risk personal money on a client with no guarantee of future success and commission. To solve this problem the packager was born; a third party administration and underwriting function acting in partnership with a lender whereby they were quite happy to underwrite up-front application costs.
As a result of consumer law consumers had to remunerate two professional advisers rather than one, unsurprisingly this led to high commission and fees.
Prior to MCD, secured loan packagers would regularly charge between 5 to 10 per cent of the loan size requested. This fee, alongside commission, would cover paying a fee to the introducing mortgage broker, valuation, third party references and operational costs.
Packagers offered potential borrowers an all-inclusive fee, payable on completion, which meant the consumer faced no up-front liability. One of the major uses for secured loans is consolidation of debt, so some people in this position welcomed with relief a product that did not require any up-front commitment.
Ostensibly advantageous, the reality with any product lacking transparency is a bad deal for consumers. Customers did not understand or know the costs of set-up and often over-estimated, meaning they were happy to pay high fees, considering it good value for money.
This problem compounded by successful applicants paying for abortive set-up costs incurred as a result of valuations being lower than expected and other cases becoming unviable for a host of reasons.
Post MCD, fee charging has parity with the first charge market where customers can pay fees associated with a transaction up-front or, where available, choose to add them to their loan. Customers are now able to understand the cost of obtaining a valuation for mortgage purposes via a European Standardised Information Sheet (ESIS) and their liability for fees is isolated to their application and unaffected by choices taken by others.
Post MCD, fee charging has parity with the first charge market , which will naturally lead to a reduction in advice fees charged in order to remain competitive. With packagers no longer forced to pay upfront costs, they should see a reduction in abortive costs, which again supports a downward trend in advice fees.
Secured loan agreements prior to MCD were structured according to consumer credit law. They contained a calculation of APR and confirmed redemption balance at a one-quarter, half and three-quarters of term.
Financial details of a proposed loan were often squeezed into a single page and, while detailed, agreements failed to provide rationale. An example of this is early repayment charges (ERCs). Under consumer credit law, ERCs were limited to one-month written notice plus 28 days’ interest, yet this explanation was never confirmed in writing, leading to difficulties in understanding how early redemption figures could be derived, despite knowing the absolute amount at three stages of the loan term.
ESIS applies to second charge mortgages from 21 March 2016 and will eventually replace Key Facts Illustration (KFI), de facto first charge disclosure document, by March 2019. The information in the ESIS will be similar to KFI, but with a different order and wording. It will also include two annual percentage of charges (APRCs). The first is based on the current interest rate, plus reversionary rate, unless the product is fixed for the duration of the loan; the second is based on the highest borrowing rate over the previous 20 years.
Without question the introduction of improved disclosures has strengthened consumer protection; consumers can now clearly disseminate all fees at various stages of the loan cycle and understand the premise for charges.
In addition, intermediaries now have to disclose exactly what service they provide so consumers can make informed choices when seeking advice.
The application and appropriateness of second charge mortgages have not changed as a result of MCD regulation. In essence, secured loans are appropriate when a capital raise requirement exists and remortgage or further advance will trigger a cost or loss of interest rate and total overall cost in comparison for a second charge mortgage is lower over a defined term (usually until cost of remortgage ends).
Avoidance of first charge early repayment charges and desire to keep low rates of interest are still the key drivers to explore a secured loan. What has improved the relevance of secured loans is downward movement in interest rates and fees. Fees have improved as a result of MCD – changes in distribution and packager risk creating a more competitive and transparent landscape, as described earlier. In order for secured loans to remain relevant it is important for overall costs to reduce as this acts to alleviate tightened affordability tests.
Chris Fairfax is managing director at Positive Lending
Key points
Prior to the introduction of Mortgage Credit Directive (MCD) on 21 March 2016, second charge secured loans were regulated as consumer credit.
Post MCD, fee charging has parity with the first charge market.
Avoidance of first charge early repayment charges and desire to keep low rates of interest are still the key drivers to explore a secured loan.
