Mortgage underfunding - a common approach on compensation?

mortgage underfunding
– a common approach on compensation?

consultation - please reply by 1 May 2001

what is mortgage underfunding?
Each year we receive several hundred complaints where the lender calculated the mortgage repayment incorrectly. The borrower paid the amount quoted by the lender, and is shocked to discover later that the outstanding balance of the loan is more than it should be. The repayment has to be increased, or the term of the mortgage extended. We call these mortgage underfunding cases.

Sometimes the problem arose because the lender quoted the wrong repayment from the outset – typically, quoting the amount of an interest-only payment on a repayment mortgage. Sometimes the problem arose because the lender quoted the wrong repayment in a notice telling the borrower about an interest-rate change.

Occasionally, a mistake in a notice about an interest-rate change may artificially extend the term of the mortgage. This may not be obvious from the notice. When the interest rate changes again, future repayment changes may be calculated on the basis of the extended term. Borrowers who think they are near the end of the term may find that in fact there are still 10 or more years left to go.

When such cases come to light, borrowers are faced with a sharp increase in repayments in order to pay off the mortgage within the original term, or the need to go on paying off the mortgage for extra years – perhaps into retirement. This paper deals with the calculation of the appropriate level of compensation in cases where we decide that the lender was 100% to blame.

Examples are given, based on a case where:

the loan was intended to be a Ł50,000 repayment mortgage over a 25 year term

the monthly payments were of interest only, because of a mistake by the lender

the mistake is discovered after 5 years, with 20 years of the term left

at that stage, the mortgage debt is Ł3,836 higher than it should have been.

building societies
The Building Societies Ombudsman Scheme has, for many years, had a published approach to compensation in these cases. Building societies are familiar with this, and (where they accept they are at fault) offer to settle in accordance with this approach. So the approach affects cases that never get as far as the ombudsman scheme.

The approach is that borrowers have lost nothing, because they will eventually have to repay the amount first borrowed. But they will suffer the inconvenience of a sharp rise in future repayments. So the society is ordered to write off half the amount by which the outstanding balance exceeds what it should have been.

In the example case, this means that the society would be required to write off Ł1,918 – half the difference between what the mortgage debt is and what it should have been.

banks
The Banking Ombudsman Scheme has for many years had a (different) published approach to compensation in these cases. Banks are familiar with this, and (where they accept they are at fault) offer to settle in accordance with this approach. So again, the approach affects cases that never get as far as the ombudsman scheme.

The approach is that borrowers have incurred a loss – to the extent that their additional future payments exceed savings made in the past as a result of reduced payments – and they have also suffered inconvenience. Typically, the award for inconvenience may vary between Ł250 or less (where the bank accepted the error fairly quickly) and Ł1,000 or more (where the bank threatened court proceedings for mythical arrears).

The loss is calculated as follows:

Work out the present-day value of the future additional payments the borrower will have to make. The present-day value involves applying a discount, because the compensation will be a lump sum payable now to cover payments to be made gradually over future years.
Deduct the present-day value of any notional past savings in outgoings. The present-day value of these notional past savings is calculated by adding notional interest.

exceptional cases
Both schemes have been faced with exceptional cases – for example, a borrower who discovers the problem shortly before retiring and has no reasonable prospect of meeting the increased future expenditure.

In such cases, depending on the circumstances, we might award increased compensation or tell the lender to leave some or all of the amount outstanding interest-free until the borrower dies or sells the house.

In the example case, this means that the bank would be required to pay the borrower Ł1,778 – calculated as shown below – plus appropriate compensation for inconvenience (likely to be between Ł250 and Ł1,000).

A	Amount actually owing on the mortgage following the mistake	Ł50,000
B	Amount that should have been owing if the mistake had not been made	Ł46,164
C	Extra amount owing [A – B]	Ł3,836
D	Extra amount owing [C] plus interest [at 8-%] as it is paid off over the remaining term	Ł7,990
E	Future loss [D] discounted [at 4%] because it will be paid now in one lump sum	Ł5,494
F	Past monthly payments which should have been made	Ł24,417
G	Past monthly payments which were actually made	Ł21,054
H	Notional past saving [F – G]	Ł3,363
J	Current value of notional past saving [H] after applying notional interest to it [at 4%]	Ł3,716
K	Estimated extra cost of paying off loan [E – J]	Ł1,778

consistency with mortgage endowment cases
There is a connection with the recent consultation by the Financial Services Authority (FSA) about compensation in relation to complaints about regulated mortgage endowments – because that canvassed a possible approach to the treatment of notional past savings:

Ordinarily, notional past savings would not be taken into account. Borrowers would probably have spent these savings unknowingly on normal expenditure. Borrowers should not have to account for past savings and should be compensated for the full shortfall to date.
Exceptionally, borrowers would be of sufficient means that it is reasonable to assume that the notional past savings actually increased their means. In such cases, borrowers should have to account for past savings to that extent (eg if they enhanced a deposit account balance).

Arguably, it would be logical and consistent to adopt a similar approach in relation to past savings when dealing with complaints about mortgage underfunding.

towards a common approach
The Financial Ombudsman Service will need to adopt a single consistent approach to mortgage-underfunding complaints by “N2” (the date when it acquires its powers under the Financial Services and Markets Act) at the latest. It could adopt either of the existing approaches, or an entirely new approach.

This is likely to involve a substantial change for banks or building societies, or for both. It would clearly be advantageous to foster a consistent approach, and for lenders and borrowers to know where they stand as soon as possible. The Financial Ombudsman Service has decided to consult now – so that it can make, and publish, an early decision about what its approach will be from “N2”.

In the light of that decision, the Building Societies Ombudsman Scheme and the Banking Ombudsman Scheme will consider whether to adopt that common approach in advance of “N2”. The existing published approaches to mortgage underfunding by both the Building Societies Ombudsman Scheme and the Banking Ombudsman Scheme are therefore suspended with immediate effect.

timing of consultation
There are significant numbers of mortgage-underfunding cases and those currently being dealt with by lenders or by the current ombudsman schemes will have to be put on hold temporarily – until the outcome of the consultation is known. Since it is desirable to keep this delay to the absolute minimum, the consultation period expires on 1 May 2001.

To ensure that consultation with the industry and with consumer bodies is as quick and effective as possible, the Council of Mortgage Lenders and the Financial Services Consumer Panel have agreed to help speed and coordinate responses from their respective constituencies. We are grateful for their assistance in this.

possible common approach
For cases where the firm is 100% to blame, we are considering the following possible approach, reflecting current views of good practice.

Ordinarily, lenders should write off the entire shortfall that has built up to the date when the mistake is sorted out.
Where appropriate, lenders should also pay compensation for past inconvenience (eg where the lender was slow to accept/correct the error).
Ordinarily, notional past savings should not be deducted.
Exceptionally, notional past savings (without interest) should be deducted if the borrowers are of sufficient means that it is reasonable to assume their means were actually increased by the notional past savings.
Ordinarily, there should be no compensation for the future inconvenience of having to make the increased payments, since these are payments the borrowers should have been paying from the start.
Exceptionally, there would continue to be cases where the approach would need to be modified in the light of circumstances. For example:

— If the borrowers were approaching retirement and could not afford the future payments, even if the whole shortfall to date were written off, they might also get some compensation in respect of the future additional payments.

— If the borrowers could not have afforded to take out the mortgage at all at the correct repayment figure, they might be put in the position they would have been in if, at the outset, they had been told the correct figure.

— If the borrowers could have afforded the correct repayment at the outset, but later ran up arrears by failing to pay all of the incorrect lower repayment, compensation might be reduced accordingly.

Ordinarily, in the example case, this approach would require the lender to write off Ł3,836 – and pay appropriate compensation for inconvenience (likely to be between Ł250 and Ł1,000). Exceptionally, if the borrower were of sufficient means, notional past savings of Ł3,363 would be deducted from this.

your comments

Anyone can submit comments direct to the Financial Ombudsman Service through:
Brenda Costello
Banking and Loans division
Financial Ombudsman Service
South Quay Plaza
183 Marsh Wall London
E14 9SR

Alternatively, lenders can coordinate comments by submitting them through
Kate Main
Policy Adviser
Council of Mortgage Lenders
3 Savile Row
London W1S 3PB
(email kate.main@cml.org.uk)

	Comments must reach the Financial Ombudsman Service by 1 May 2001.
	Unless they are marked confidential, we will assume they can be published.

and finally
Not unnaturally, customers expect financial firms to calculate figures accurately. Mortgage underfunding complaints would not arise if firms had simple checks in place, to ensure the initial calculation was right. But, regrettably, the number of mortgage underfunding cases we receive is not diminishing.