Monday, March 20, 2017

Why is “arrears capitalisation” so difficult to understand?

The most common mortgage restructure currently used by lenders is “arrears capitalisation”.  Of the 121,000 PDH mortgage accounts that have been restructured, 38,500 have had this restructure applied to them.  It might be the most frequently used but it is also the most misunderstood.  One report states:

Arrears capitalisation, where arrears are added to the principal of the loan, was the most common form of restructure, comprising almost 22 per cent of the total, followed by “split mortgages” at 22.4 per cent, where part of a loan is warehoused for an agreed period.

This is wrong.  Arrears should never be added to the remaining principal.  We pointed this out two years ago but it still persists.  And a large part of the blame rests with the Central Bank.  Footnote 2 of their release says:

Arrears capitalisation is an arrangement whereby some or all of the outstanding arrears are added to the remaining principal balance, to be repaid over the life of the mortgage.

The only way someone can owe more when they miss payments is because of accrued interest; the fact of missing payments or going into arrears does not have an impact on the amount owed.  Adding arrears to the amount owed should never happen.

Consider a simplified situation of a loan for €120,000 to be repaid over 10 years.  To focus on the impact of arrears we will assume that the interest rate is zero.  Adding a positive interest does not change the argument.  So in this no-interest situation 120 payments of €1,000 a month are required to repay the loan over ten years.

Let’s say the borrower makes the payments for three years but then misses payments for an entire year.  The three years of payments (€1,000 x 12 x 3) will have reduced the balance to €84,000 and the year of missed payments will result in €12,000 in arrears.

At the start of year five the borrower is in a position to resume payments and engages with the lender.  The lender tells the borrower that the remaining balance is €84,000 and that there are €12,000 of arrears.  There is no basis for saying that the amount owed is €96,000 or any number other than €84,000.  It is nonsense to suggest so.  The borrower has borrowed €120,000, has repaid €36,000 and therefore owes €84,000.  With zero interest to be added that can only be the amount owed.

What is termed “arrears capitalisation” would actually be better described as “arrears amortisation”.  When the borrower engages with the bank at the start of year five there is a outstanding balance of €84,000 and six years remaining on the life of the loan to repay it.  Resuming payments of €1,000 per month will be insufficient to repay the loan over the remaining term.  Those payments would sum to €72,000 (€1000 x 12 x 6) so the shortfall would be €12,000, i.e. the amount of the arrears.

To ensure that the €12,000 of arrears is repaid over the life of the loan the monthly repayments are recalibrated to take account of the missed payments.  So repaying €84,000 over six years with no interest requires monthly repayments of €1,167.

The monthly repayment has gone up but it is not because any arrears have been added to the balance.  The payment has gone up to ensure that the arrears are paid once, not twice.  Under no circumstances should arrears be added to the balance.  The monthly payments have gone up because the borrower has a shorter period within which to repay the loan.  If the payments weren’t increased there would be a shortfall at the end which, in our simple case with no interest, would be equal to the amount of the missed payments.

In the case of our borrower with a debt of €120,000 the payments made are:

  • 36 x €1,000 for the first three years
  • 12 x zero for the year of missed payments
  • 72 x €1,167 for the remaining six years of the term.

The total amount repaid is €120,000.  If the arrears has been added on the total amount repaid would have been €132,000.  And if the borrower has missed two years of payments the total would have been €144,000.  How can the act of missing payments increase the amount that is owed?  Only interest can do that.

With an “arrears capitalisation” the payments are changed to ensure that the balance is paid over the term of the loan.  There is nothing added to the amount owed.  But I’m guessing there will be additions to the number of times we see it being said.

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