By Michael Baxter 8 Sep 2010 [3 Comments | 686 views]
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Property bulls say it’s affordability that matters, not house prices. It matters not if house prices relative to earnings are high; what matters is the rate of interest. But the bulls have forgotten something rather important. And now a new move from the banks, which are said to be ditching many interest-only mortgages, is set to expose the error in the bull’s logic.
According to a recent report in the Telegraph, mortgage lenders are now attempting to migrate their customers whose mortgage is for more than 75 per cent of their property’s value, away from interest-only mortgages.
To be honest, it’s about time.
Interest-only mortgages are a legacy of the time of madness. On the eve of the economic crisis, one forecasting group predicted that house prices would eventually rise such that average prices would be ten times average income. When our mortgages are interest only, and no one cares about repaying the principal, this prediction did have a slight ring of logic about it. But throw in the little matter of repaying the initial sum borrowed, then this forecast looked crazy.
Think about it. Assume the average family pays 50 per cent of their gross income in tax – that includes income tax, council tax, NICs and VAT. And assume the family has just one income earner. Even if the interest payments on the mortgage had been zero, then to buy a property worth ten times income this person would have to pay 100 per cent of net earnings on repaying the mortgage for 20 years.
Interest-only mortgages only make sense in a regime in which house prices are permanently rising, or one in which inflation is unusually high, say above 10 per cent.
Interest-only mortgages stand as a metaphor for all that was bad about the boom.
Of course, there is another piece of madness behind the affordability argument. Those who say high house prices are justified when interest rates are low, forget two important points. Firstly, a mortgage is typically for a 25-year period. Secondly, interest rates can swing wildly over a time span stretching a quarter of a century.
But if the Telegraph is right, and we are indeed seeing a move away from interest-only mortgages, then the ramifications are quite serious.
Capital Economics put it this way: “For a home-owner borrowing £150,000 at 3 per cent, moving from an interest-only to a 25-year repayment mortgage would increase their monthly payment by £336, or 90 per cent.”
One of the more bizarre aspects of the recession is that household affordability did not fall. Job losses, as you know, were less than feared. Low interest rates meant our heavily indebted consumers often found they were better off.
This contrasts with the boom, when discretionary household disposable income fell between 2003 and 2007. See: What kind of recession was that? – households were no worse off
The next year or so is likely to see household disposable incomes contract. The move to end interest only mortages, as sensible as it is, will ensure this fall is even greater.
Whilst I agree that over the last 10-15 years house prices in the UK have been overpriced, I’m not quite sure that there is validity in the argument that ‘interest only’ is evil and ‘repayment’ is good. To some extent this is only an argument for effectively restricting access to capital. Say I use the alternate of renting instead of buying, then over time my rent will increase, if I borrow then over time my monthly payment will be the same but inflation will erode that cost in real terms – so I’ll be better off. At the end of the 25 year term I could either extend the mortgage, or pay it off if the amount is now relatively small. Either way, in the long term I’d likely be better off than those that are still paying rent.
By restricting to ‘repayment’ terms and therefore reducing the ‘affordability’ of the cost of the loan it’s clear that this would put the brakes on the market. Perhaps, simply legislating the loans based on the old formulae of max 3.5x single or 2.5x dual income would not only make for more predictability in the market but allow for more social stability.
The ‘return to reason’ may come at just the wrong time, given the other strains likely to develop on household incomes – as you imply in your final para above.
Many rational market watchers have been predicting (or perhaps hoping
for) stagnation or orderly decline in house prices, in order to return them to sensible levels relative to incomes. But we may now be about to see a combination of sparks that could set off a major crash. Let’s hope not.
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