No Buy-to-Let lender has been unaffected by the economic noise since the beginning of the year, with all needing to raise rates and – in some cases – remove products or halt lending altogether.
This can be frustrating for brokers and their clients because, depending on how the lender handles the rises, these changes can come at short notice.
So what is driving increased rates among specialist lenders, and what should brokers look for in their Buy-to-Let lender in the coming months?
How Buy-to-Let lenders are funded
Most Buy-to-Let lenders get their funding through facilities with global financial institutions, which range from investment banks to high street banks, and pension funds to credit funds.
When these facilities are arranged, the financial institution expects a return derived from 2 components, (1) a fixed margin, to compensate them for the risk they’re taking and (2) a risk-free floating rate, such as SONIA, (Sterling Overnight Index Average), which has mostly replaced LIBOR.
Expected Return = Fixed Margin + Floating Rate
The Lender will arrive at the price of their mortgage products using both of these components, but since the floating rate can change during the facilities’ life, the pricing of the products will need to be changed in order to protect returns/margin.
Swap rates and SONIA
A vanilla interest rate swap contract is a tool to help protect returns/margins when interest rates are going up.
An interest rate swap is an agreement between two parties where one agrees to exchange their variable interest-rate cashflows for fixed-rate cashflows. These agreements can come in many forms and can be very bespoke in nature, but in the case of Buy-to-Let these are typically entered into in line with the fixed-term of the underlying loan.
The variable or floating element of this swap is set by SONIA, which replaced LIBOR as the method for how banks calculate the cost of lending between one another on an overnight basis.
The SONIA interest rate exists as a benchmark to provide the best indication of an almost risk-free interest rate, similar to that of the Bank of England’s (BoE) Base Rate or GILTs. The rate is informed by a number of economic and credit factors, but also by the probability that the lending bank will be repaid the next day, therefore it is a rate set on a daily basis.
Swap rates typically go up on a curve the longer the term, however the reverse happens in times of economic uncertainty.
Almost all non-bank Buy-to-Let lenders’ are required by their funders to enter into these swaps to lock in a price on the floating rate element for the lender, which is the swap rate at the point the swap is entered into.
The reason for this is to protect the lender from an unexpected rise in the floating rate element, of the expected return paid to the funder, causing financial difficulties for the lender and ultimately the funder
What has been happening recently
As mentioned above, the SONIA swap rate is informed by a number of economic and macroeconomic factors, this includes information like inflation stats and the BoE Base Rate.
While the SONIA rate is separate, it is closely linked to the BoE Base Rate, the swap rates are essentially a prediction of what the BoE Base Rate will be over the period of the swap.
This means if the market predicts that there will be a large number of rate hikes in the near future the swap rate will price that in, well before the rate hikes happen. In a calm market changes to the swap rate are gradual, however, in times of economic uncertainty movements can be quick and drastic.
For example, over the month of August the rate for swaps of lengths 2 to 10 years increased by over 50%.
This has a knock on effect on lenders, for example:
A lender has a 5% product. The expected return to the funder is a fixed margin of 2.5% plus the floating rate of SONIA. At the time the product is released the SONIA rate is 2%. This makes the cost to the lender 4.5% of rate, with 0.5% wiggle room for its costs. If the SONIA goes up to 3%, and drives the swap rates up, this means the lender is making a loss on that product, which it can’t afford to do.
This is why lenders are often repricing a lot and at short notice, as the volatility in the swap rates informs their products and can push them into a place where they aren’t offering sustainable loans to brokers and their clients.
The 2 year and 5 year swap have been roughly less than 1% since 2015, but since the beginning of the year swap rates have increased to 4% for 2 year and 3.5% for the 5 year.
What can brokers and their borrowers expect in the near future?
The Bank of England has increased the frequency with which it meets to try and bring down inflation, and this might lead to increased base rate rises.
The SONIA swap rate will often change in anticipation of these meetings as it factors in daily information, and it is the broader mood around the economy that will help inform where interest rates go, whether it is up or down.
What should they be on the lookout for?
As we explained, the SONIA swap rate varies depending on how many years the fixed-rate mortgage will last for and therefore the duration of the required swap. If the short-term outlook is poor, it will raise rates sharply on short-term fixes. This is why we’ve seen some lenders remove two-year products from the market entirely.
Longer-term fixes should be more resilient and it is why you’ve seen more lenders adopt 7- and 10-year products.
As we navigate the economy, brokers need to look towards factors away from rate, like reliability and speed of service in seeing deals done quickly and before the situation changes.