Paying in instalments
Deferred premium strategies
This article discusses paying the premium for a cap or floor in instalments rather than upfront. The risks, benefits and mechanics of strategy are analysed from both the lender’s and the borrower’s perspective.
The premium for a cap or floor is normally paid upfront by the borrower. This is generally the case when the option is purchased independently of the loan or loans it is hedging.
Some borrowers prefer to pay the premium in instalments.
Some lenders may offer deferred premium options, where the premium is payable in instalments over the life of the instrument regardless of what happens to interest rates. By deferring the premium payable, the lender is effectively lending the borrower the money to pay the premium so will apply a funding charge and may require additional security.
Borrowers may create their own ‘do-it-yourself’ deferred premium payments by borrowing extra to pay the upfront premium cost and then repaying the extra amount borrowed in instalments over the life of the loan.
Paying the premium in instalments avoids the need for an upfront payment. But the instalment payments effectively add to the interest costs of the loan or loans being hedged.
The amount of each instalment depends on the upfront price of the option, the length of the repayment period and the funding rate applied.
Deferred premium instalments remain payable regardless of what happens to interest rates and whether the borrower chooses to redeem the cap or floor early.
Lender instalment options
Risks and benefits
Lenders offering instalment payments for a cap or floor are effectively lending the borrower the money to pay the premium. A funding charge will apply to the extra amount borrowed and additional security may be required.
The upside is that the lender is likely to experience stronger customer demand for the cap or floor, because some customers prefer to pay the premium in instalments rather than upfront.
The benefits of incorporating caps and floors into loan products include reduced overall risks, increased fee income and higher risk-adjusted returns.
Higher customer demand
Lenders offering caps and floors are likely to experience higher customer demand for their underlying loan product, regardless of whether they also offer borrowers the option to pay in instalments.
This is because applying caps to floating rate loans or floors to fixed rate loans provides optimal capped financing for the borrower. Adding capped loans to the range of products offered increases the number of potential customers for each underlying loan:
- Borrowers willing to take the risks of fixed rate financing may take an underlying fixed rate loan on the normal basis.
- Borrowers willing to take the risks of unhedged floating rates may take an underlying floating rate loan on the normal basis.
- Borrowers preferring to avoid the risks of fixed rates and uncapped floating rates may take the same underlying fixed or floating rate loan transformed into a capped loan via the addition of the cap or floor.
Whichever option is selected by the borrower, the lender’s net cash flows remain unchanged from those of the original underlying loan.
Offering instalment payments for the cap or floor may further increase borrower demand, because some customers prefer to pay the cap or floor premium in instalments rather than as a single upfront payment.
Reduced overall risks
By deferring the premium payable, the lender is effectively lending the borrower the money to pay the premium. The extra money lent may require additional security.
But the lender’s overall risk position is likely to be strengthened:
- More potential customers for each underlying loan enables the lender to apply stronger credit criteria in general.
- Interest coverage may be improved. Customers with the benefit of caps and floors pay less loan interest so are better able to meet loan obligations.
- Loan to value ratios are improved by the lender’s ownership of the applicable caps and floors, which provide the lender with additional security.
Increased fee income
Lenders offering instalment payments may earn increased fee income including by adding an upfront margin to premium, applying a spread to the potential cap or floor income, adapting the funding rate for the deferred premium, applying higher loan fees or any combination of these.
Higher risk-adjusted returns
Risk-adjusted returns are improved by increasing returns for the same level of risk or by reducing risks for the same level of return.
Increasing returns and simultaneously reducing risks accelerates the positive impact on the lender’s risk-adjusted returns.
Borrower instalment payments
‘Do-it-yourself’ deferred premium payments
Borrowers can use a cap or a floor to get improved access to suitable finance: cheaper loans, in larger amounts, from a wider choice of lenders, at lower risk and with optimal loan interest. The benefits are explained in this article.
The downside is normally the need to pay the upfront premium for the cap or floor. Some borrowers prefer to pay the premium in instalments rather than upfront. But some lenders do not offer deferred premium options.
The solution for borrowers is to create their own ‘do-it-yourself’ deferred premium payments by borrowing extra to pay the upfront premium cost and then repaying the extra amount borrowed in instalments over the life of the loan.
The instalment payments effectively add to the interest costs of the loan or loans being hedged. But paying the premium in instalments avoids the need for an upfront payment.
The amount of each instalment depends on the upfront price of the option, the length of the repayment period and the funding rate applied, as shown on the instalment calculator [link to calculator].
Deferred premium instalments remain payable regardless of what happens to interest rates and whether the borrower chooses to redeem the cap or floor early.
How are deferred premium options priced?
Factors affecting the instalment payments
The instalment payments depend on the upfront price of the option, the duration of the instalments period, the number of instalment payments per year and the funding rate applied.
Upfront price of the option
For a given interest rate environment, the amount of the cap or floor premium is determined by three key factors, the loan amount protected, the duration of the protection and the cap or floor rate.
Duration of the instalments period
The longer the duration of the instalments period, the less each instalment will cost, but the higher the total payment, because of the funding cost applied to the deferred payments.
Funding rate applied
The higher the funding rate applied, the higher the cost of each instalment.
If the instalments for a cap are funded on a floating rate basis, the instalment costs will depend on the floating rate. The floating instalment costs can be hedged by increasing the amount protected by the cap.
Examples table
The table below shows examples of instalment premiums according to the upfront premium and the duration of the instalments period.
[TABLE TO BE ADDED].
For precise calculation of the instalment costs for a particular cap or floor option, please use the instalments calculator [link to be added].
What are the risks of deferred premium options?
Lender and borrower perspectives
[Risks section to be added].