Although the wording of the terms of LV’s member mortgage loans has changed to some extent over time, they generally state that interest rates are determined with reference to interest rates set by the Central Bank of Iceland, yields on government bonds, the Fund’s risk assessment at any given time, and the cost of administering the loans.

It is appropriate to explain in further detail the basis for the determination of interest rates on member mortgage loans under their terms.

The determination of interest rates on member mortgage loans is based on a theoretical framework

Interest rate decisions are based primarily on a so-called interest rate bridge, a methodology that involves calculating an interest rate spread on top of risk-free interest rates. Risk-free interest rates are assessed with reference to interest rates set by the Central Bank of Iceland and yields on government bonds, while the interest rate spread reflects each of the risk factors applicable to member mortgage loans.

The pricing of member mortgage loans is calculated using a methodology that takes into account the following factors:

• Risk-free market interest rates. Here, reference is made to interest rates set by the Central Bank of Iceland, together with yields on government bonds in the securities market. Together, these interest rates form a so-called risk-free yield curve for different maturities. This makes it possible to assess risk-free interest rates for different maturities based on Central Bank interest rates and bond market rates at any given time. The interest rates corresponding to the maturity of each loan type are then used as the risk-free interest rates for the relevant member mortgage loan.
  
  For example, a member mortgage loan with a fixed interest rate for three years is based on risk-free interest rates of a comparable maturity, plus an interest rate spread. Similarly, loans with variable interest rates, without a fixed-rate period, are based on the shortest risk-free interest rates, plus an interest rate spread.
• Covered bond spread. Here, reference is made to the spread of covered bonds over government bonds with the same maturity as the fixed-rate period of the relevant member mortgage loans. The commercial banks’ covered bonds are secured by collateral in their diversified residential mortgage loan portfolios and therefore have, to some extent, characteristics comparable to member mortgage loans. The yield required by investors for such bonds therefore forms a basis for the pricing of member mortgage loans.
  
  For loans with variable interest rates, reference is made to the shortest covered bond spread observable in the market, or to a best estimate where applicable.
• Borrower spread. In determining interest rates on member mortgage loans, the Fund carries out a risk assessment in which it assesses a borrower spread reflecting the additional risk assumed by the Fund when lending to an individual, compared with holding covered bonds.
• Liquidity spread. Here, consideration is given to whether a bond is liquid, as is the case with government bonds, or whether a discount would likely have to be applied upon sale, as is the case with illiquid bonds. Member mortgage loans are classified as illiquid bonds, and this is reflected in the interest rate spread.
• Administration spread. Here, consideration is given to the cost arising from the administration of member mortgage loans. This includes both the operation of the lending department and the involvement of the Fund’s specialists, whether from asset management, risk management, the Fund’s legal department or other departments of the Fund involved in the administration of member mortgage loans.
• Prepayment spread. Here, consideration is given to pricing the borrower’s option to prepay a loan without a prepayment fee. For a lender, it is preferable to secure interest income over a longer period rather than having the member mortgage loan prepaid earlier than provided for in its terms, in which case the funds would have to be reinvested, potentially on less favourable terms. The right of prepayment is therefore priced and reflected in a prepayment spread.

Together, the above six factors form the basis of the methodology used when preparing interest rate decisions for member mortgage loans. These factors may change in line with developments in the securities market at any given time. If the Central Bank of Iceland raises interest rates, it can generally be expected that yields on government bonds will rise and that the interest rates on member mortgage loans will then increase. The same applies when the Central Bank of Iceland lowers interest rates; in such cases, interest rates in the securities market will generally fall, and this is reflected in the interest rates on member mortgage loans.

However, interest rates on member mortgage loans do not change immediately in line with market changes, as the Fund requires a certain degree of flexibility to assess market fluctuations and respond to them in an appropriate manner.

The initial interest rate is fixed for five years (60 months) and is based on the member mortgage loan interest rates offered by the Fund at any given time.

At the end of the first fixed-rate period, successive five-year fixed-rate periods will apply for the remainder of the loan term. The interest rate will be based on the Central Bank of Iceland’s par rates, plus the Fund’s fixed interest rate spread, in accordance with the further provisions of the terms of the Fund’s mortgage loans. However, the interest rate may never be lower than the specified interest rate floor set out in the mortgage bond.

• The Central Bank of Iceland’s par rates constitute reference interest rates within the meaning of Article 34(1) of Act No. 118/2016 on Consumer Mortgage Loans. The Central Bank of Iceland’s par rates refer to the inflation-indexed Government bond constant maturity par rates (FLVR), being the par rates calculated and published by the Central Bank of Iceland on its website. They show, on each business day, the interest rate and yield that new Treasury coupon bonds with maturities of three, five and ten years (in this case five years) would bear if they were issued on that day at par, i.e. at a price of 100.
• Interest rate reset: The reset of the par rates is carried out as follows. Generally, 30 days before the end of each 60-month interest rate period, the creditor calculates, on the reset date, the average of the inflation-indexed constant maturity par rates of the Central Bank of Iceland, as published on the Central Bank of Iceland’s website for the first 10 (ten) business days of the preceding calendar month. Those par rates, together with the fixed interest rate spread, will form the fixed interest rate for the next 60-month interest rate period. The reset total interest rate, i.e. the par rates plus the interest rate spread, takes effect on the next payment due date after the reset date, but never before the 30-day notice period has expired.
• If the Central Bank of Iceland ceases to publish par rates as described above, the interest rate that replaces the Central Bank of Iceland’s par rates upon the reset of the par rates, whether pursuant to laws, regulations or rules, a decision of the Central Bank of Iceland or other administrative instructions, shall become the new reference interest rate for the loan in place of the Central Bank of Iceland’s par rates. If no interest rate replaces the Central Bank of Iceland’s par rates, the creditor shall, on the basis of a fair assessment, determine the reference interest rate or reference index that most closely approximates the Central Bank of Iceland’s par rates and satisfies the requirements of law. That rate or index shall replace the Central Bank of Iceland’s par rates upon the reset of the par rates, and the creditor shall notify the borrower thereof with 30 days’ notice.

The interest rate is fixed for three years (36 months) and is based on the member mortgage loan interest rates offered by the Fund at any given time.

At the end of the fixed-rate period, the interest rate will become variable and will consist of a variable base rate and a fixed interest rate spread. The variable base rate is the Central Bank of Iceland’s key interest rate (policy rate) at any given time. However, the interest rate may never be lower than the specified interest rate floor set out in the mortgage bond.

• The key interest rate constitutes a reference interest rate within the meaning of Article 34(1) of Act No. 118/2016 on Consumer Mortgage Loans. The key interest rate means the interest rate in the Central Bank of Iceland’s transactions with credit institutions that has the greatest effect on short-term market interest rates at any given time, and which the Central Bank of Iceland determines and publishes on the basis of Act No. 92/2019 on the Central Bank of Iceland. Information on the key interest rate at any given time is available through the Central Bank of Iceland’s information service, currently at sedlabanki.is.
• If the Central Bank of Iceland ceases to determine and/or publish the key interest rate, the reference interest rate that replaces the key interest rate, whether pursuant to laws, regulations or rules, a decision of the Central Bank of Iceland or other administrative instructions, shall become the new reference interest rate for the loan in place of the key interest rate during the variable interest rate period. From that point onwards, the base rate of the loan will change in accordance with changes in the new reference interest rate. If no reference interest rate replaces the key interest rate, the creditor shall, on the basis of a fair assessment, determine the reference interest rate or index that satisfies the requirements of law and most closely approximates the key interest rate. That rate or index shall replace the key interest rate, and the creditor shall notify the borrower thereof with 30 days’ notice. From that point onwards, the base rate of the loan will change in accordance with changes in such new interest rate.