11 Feb 2012, 2:05pm
personal finance rant:
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  • Why the Demise of the Interest-Only Mortgage isn’t a bad thing

    So you walk into a shop, and spot that nice new flat-screen TV you want. £500 to you, sir, or you can buy it interest-only for £2 a month. Wouldn’t you smell a rat somewhere? The rat is, of course, the small print that says you’ll have to pay £500 at the end of the interest-only loan.

    Now I know that some people, particularly in the United States, buy their cars like this. It is called leasing, and the name gives it away, you never get to own the car. It’s a long term rent. It looks absolutely and stupendously daft to me, but if the image of driving a nearly new car is that important to you, well, ‘you pays your money and you takes your choice‘.

    So what the heck makes buying a house on an interest-only mortgage any different? You still never get to own the house. What it the point of that? The interest only mortgage was a clever wheeze to ramp up house prices and for banks to make more money. The beautiful part of this game is that the buyers go all gooey-eyed and think the mortgage company is doing them a favour by lending them more than they can afford. Hey, that Mr Interest Only Bank can lend me £200,000 whereas Mean Old Prudent Bank will only lend me £150,000. Isn’t Mr Interest Only Bank such a nice guy?

    Two words. Northern Rock. It didn’t work out well, even for the lenders.

    A history lesson

    1960 – the Repayment mortgage

    When my Dad borrowed his first £500 mortgage, way back in the early 1960s, it was simple. He told them his income, they looked up in a table what they could lend him, and armed with that knowledge he could look for a house. He borrowed the £500, and then paid them the interest plus a proportion of the price of the house, the latter proportion increasing with time.

    Repayment mortgages were all that were available, based on the simple premise that you pay your instalments for 25 years and when the last one is paid the house is yours.

    1990 – the Endowment Mortgage

    Fast forward thirty years, and I get to go to the Abbey National, and bamboozled by the choice of endowment and repayment I foolishly go for an endowment mortgage. This is still on the principle that I pay interest only to the mortgage company, but simultaneously to a life-insurance policy which supposedly grows with time till after 25 years it is worth at least the price of the house. So although I was only servicing the interest on the mortgage, I was in parallel accumulating an asset that matched the cash price of the house, which when paid to the mortgage firm would discharge the debt. And the house would be mine. The mortgage company took a charge over the endowment, so I couldn’t sneakily stop paying it without them knowing.

    2005 – The Interest Only Mortgage (Don’t Bother with the Capital, it’ll work out somehow)

    Like an endowment, but endowments got a bad name, for not paying enough to match the price of the house. So just do away with the need for an endowment! How does that work? Well, you get to the end of your 25 year term, and you still owe for the house! Okay, so inflation hasd probably halved the real value of the debt, which is all to the good, but you still don’t owe your damn house at the end. It is a leasing arrangement. Why not just rent instead?

    The assumption is that rampant house price inflation means that your house is worth so much at the end that the increase covers the total. But you still can’t sell off the chimney or your third bedroom to discharge the debt, and you are likely to be coming up for retirement. I wouldn’t want to have to stick my hand in my back pocket to come up with what I paid for my house over a decade years ago, though as it is I could just about do it.

    increasing complexity, decreasing security and honesty

    There’s a lot of bleating about interest only mortgages, because about a third of firt-time buyers bought their houses on an interest only basis.

    Shockingly, I heard a father talking on Money Box about how it was so rotten that his son couldn’t find an interest only mortgage to buy his first house. David from Sussex said (13:45 on the iPlayer)

    a bit surprised and disappointed to hear they’re only looking to offer capital repayment mortgages, and with my son’s circumstances, which I’m sure is the same for a lot of other first time buyers, the intention is not to stay in the property for that long

    So how does that work, then, David? Are you saying your son doesn’t need the house after a while, can sell up, pay back the capital from the proceeds and stick a tent on the pavement? Or do you want him to be able to overpay for this house, so he doesnt’ spend the excess on booze and fast cars? Why exactly is it that you want him to borrow more money for a house he can’t afford the buy, only to lease? Do you realise, David, that your son is in an auction for houses, and if mortgage companies don’t let people borrow so much money then the auction price will fall?

    It’s too late to save the people that did overpay for houses by going interest-only to the max, but we can at least not propagate the mistake. If you are going to buy a house, then buy the damn thing, don’t lease it for 25 years and then wonder why it isn’t yours…

    Overall, look at the changing mortgage proposition over the years. My Dad was offered an honest and straightforward service. Pay this much for the next 25 years, and you will own your house.

    I was offered a less honest service but at least one that in theory would end up with me owning the house. It didn’t work out that way because the complexity of a with-profits endowment hid untestable assumptions and I was stupid enough to buy a product that didn’t match my circumstances. In all fairness to my parents, they told me a repayment would be better for me, they told me why, and educated me well enough to be able to see why, but I was a damn fool and had eyes only for the potential gain, without the wisdom to look for the potential loss. That’s what being 28 did for me, I knew everything and nothing, so greed trumped wisdom.

    Unlike my parents, David is failing his son in giving him only half the story. If he actually told his son, “look, you are taking a very serious risk here by going interest only, but you are in a profession where your pay will increase dramatically and as long as you start saving for the capital from then on you may consider this a calculated risk” then that would make all the difference.His son would still be taking a risk and would probably be just as cocky as I was, but at least David would have discharged his duty as a parent ;)

    He sort of alludes to the early years being hard, but wage profiles may be flatter nowadays and young people start out with more debt, so the assumption that money will be easier after five years probably doesn’t hold. David needs either to underwrite his son’s migration from interest-only to capital repayment with the Bank of Mum and Dad, or not encourage his son to overpay. Because it’s simple to summarise the issue

    if you can only afford to pay an interest-only mortgage on your house, then you can’t afford to buy that house.

    Although I think the demise of the interest-only mortgage has been exaggerated, its death would be no bad thing at all.

    Perhaps the only place where an interest-only mortgage might help would be to buy a property in London, take advantage of the inflating prices (despite the recession) and then sell the property in a few years time to move out of the city to a cheaper location – think of it as renting in London but with the advantage of a capital gain at the end of the rental period.

    I’ve got a couple of friends who have gone down this route and it will be interesting to see how it works out for them in the long-term.

    For me personally, it all sounds fairly complex and i’m happy with my bog-standard repayment mortgage, especially with the interest rates being as low as they are at the moment. I made a decision to buy outside London simply because I could not afford the repayment charge each month on a decent London flat at the time and didn’t want to risk it with an interest-only.

    “if you can only afford to pay an interest-only mortgage on your house, then you can’t afford to buy that house.”

    … but but but … how else can we get on to the slippery slope to debt peonage, sorry, housing ladder???

    Again, 100% agreement, yet it seems the most obvious basic truths are beyond 99% of the population. (Not to denigrate the 99%, of course, who are a political force to be reckoned with despite their lack of leaders or focus or suggestions for a way forward…) But I can’t help wondering, what part of wanting to be blindfolded and led through the valley of darkness by strangers of unknown ethicality spells out ‘responsible adult’? Cos frankly I can’t see it.

    Where exactly can we draw that line between ‘we wuz robbed’ and ‘we wuz stooopid’?

    Maybe if ‘interest only’ was time limited (say one year?) before rolling automatically into repayment mode, it would help people to focus on something beyond their navel-fluff and the Sunday supplements. But I doubt it… and someone else can hold their breath, don’t look at me ;-)

    @MoneySavingChallenge, yep, London is always a special case, and your competitors in the hosuing market aren’t just drawn from locals. It is still high risk, because of the old problem that the market can stay irrationa for longer than you can stay solvent.

    Another case where interest only is fine is where the house is a business asset, eg BTL, but it’s not a typical FTB loan.

    @Macs I fear it takes age and experience to call the line between ‘we wuz robbed’ and ‘we wuz stooopid’?. I can write ‘I was stupid enough to buy a product that didn’t match my circumstances’ from the perspective of 20 years, but when I launched my claim against the endowment firm 10 years ago it was from the persepctive that I wuz robbed. I wasn’t, I was greedy. Fortunately for me I was given an out by the FSA, and the LAUTRO salesforce did take advantage a bit but I can’t actually say I wuz robbed because I had been amply forewarned ofthe endowment trap by my parents.

    Since then I’ve tried to take my own errors of judgement on the chin and learn from them ;)

    Maybe if ‘interest only’ was time limited (say one year?) before rolling automatically into repayment mode

    Wasn’t that called an adjustable rate mortgage (ARM) over the Pond, which got an awful lot of people into trouble by letting them buy houses they couldn’t afford to repay? It’s a great idea for trainee solicitors and accountants, and a weapon of mass destruction for the rest of us. At least in the States people could walk away from the mortgage without recourse from the lender, over here it would be lethal IMO!

    If we were really smart and not afraid of sudden dramatic economic crashes, that accelerate along with the acceleration of history, but I digress, we’d try and get variable rate mortgages that allow us to “lock-in” at a higher rate should a new drama transpire, as in the seventies of yore when runaway inflation suddenly made everyone poorer and from which many (99%) never recovered.

    I’m one of those awful, terrible, horrible, stupid people who have a Northern Rock “Together” mortgage; you know, the thing where they’d lend you up to 125% of the value of your house with no deposit?

    But here’s the thing – I didn’t want to go with NR, but my preferred mortgage company wouldn’t lend on an ex-council house (how lovely of them!), and I didn’t take anywhere like the sum they were offering me – IIRC, they were willing to lend me about £115,000. With no deposit, and no guarantor, and it was just me buying on my own (1 income), and my income at that point was not that fantastic!!!

    Now, I am, I hope, quite sensible when it comes to money, and even though I did borrow more than the cost of the house, I actually only borrowed just over 3 times my salary, in the expectation that it would increase over time.

    It has, and I now owe less than three times my current salary. BUT, the house is, overall, in negative equity, which everyone other than me seems to think is a massive problem (a helpful comment from a work colleague “ohh, I couldn’t sleep at night if I knew I was in negative equity”), although I don’t. I’m actually up on my payments (I make a very small overpayment each month), if my job goes south I have three months of payment holiday, the option to use up the overpayments and MPPI to hopefully keep the roof over my head, and I NEVER INTEND TO MOVE. This is something that I think has got forgotten in the madness of “interest-only” products, the mistaken belief that prices can only rise, and the ludicrous dinner party conversations of “I’ve made a killing on my house – it’s worth £XXX more than when I bought it” (no, you haven’t, it’s worth nothing until you sell it, and if you did go the traditional repayment mortgage route, calculate what you’ve actually paid to the mortgage company and you’ll quickly sober up about “how much you’ve made”) all of which has combined to make people absolutely and completely irrational about houses and homes and property ownership.

    If I was in charge, everyone who was buying to reside in the property would have to have a repayment mortgage, and the statements you get sent would have to have an additional section showing how much you’ve paid in total since the start of the mortgage and how much you can expect to pay over all if you don’t repay early. That alone might just start to get house prices back to a point where they are in reach of the average person on the average wage!

    “Maybe if ‘interest only’ was time limited (say one year?) before rolling automatically into repayment mode”

    I had a mortgage like this when I first bought in 2002. HSBC called them a graduate mortgage and you had 3 years, if I remember correctly, before starting repayments. I actually moved across early to a repayment mortgage, being the risk averse character I am!

    10 years later and I am looking at interest only/offset mortgages again. There are two key reasons I think they are worthwhile – a) savings are earning a pitiful rate elsewhere and the offset rates are close enough to repayment rates to make them worthwhile and b) I would like the flexibility to drop to interest only in the case of redundancy.

    Initially I would set it up as if it were a repayment mortgage – then relative interest rates would determine whether I overpaid the mortgage or saved/invested elsewhere. I guess this is almost going down the route of an endowment mortgage.

    @g you’re actually describing the typical UK situation, where mortgages are variable rate, though short-term (2-5year) fixes are available :)

    @Anne, you are quite atypical for an interest-only borrower; if you were borrowing on less than 3 x salary this implies to me that you would have been able to afford a regular repayment mortgage.

    I was in your position in the 1990s – although paying down an underwater mortgage is depressing it isn’t actually a problem until you move. I only moved when I was able to walk away from half the overvalued price I paid, like you I experienced significant career progression that helped me do this.

    As you indicate though, if it were such that anyone buying to live in a house could only get a repayment mortgage, then it might push house prices down to more reasonable levels. You would still have been able to buy your house when you did, even at the price you paid, but you’d have a repayment mortgage. I don’t have a problem with a 100% repayment mortgage, but I do think a 100% interest only mortgage is a weapon of wealth destruction!

    @Deb, offset mortgages are a great idea. Bear in mind, however, that your savings can usually be seized and applied to discharging part of your mortgage if the institution thinks there is good reason to do so.

    Another alternative is a flexible mortgage. The one I had with Birmingham Midshires allowed me to overpay, but to drawdown the overpayment. So I overpaid to reduce the capital, and did have to drawn down some of that towards the end before paying down the lot. Again, the ability to drawdown may be withdrawn under certain circumstances. This is functionally the same as an offset mortgage, but without seeing the offset explicitly.

    I also paid down to hedge job hazards, there have been quite a fed nights of the long knives over the years. There’s nothing wrong in Saving or investing elsewhere provided you a) choose an investment that is transparent unlike an endowment was; a S&S Isa fits the bill very well as long as your house costs < £250,000 (25 years worth of 10k contribs) and b) derisk your investment towards the end by slowly switching it into cash over the last five years. I’m all for it, though it is a sophistication which would have been well beyond my 28-year old self.

    “I also paid down to hedge job hazards, there have been quite a fed nights of the long knives over the years. There’s nothing wrong in Saving or investing elsewhere provided you a) choose an investment that is transparent unlike an endowment was; a S&S Isa fits the bill very well as long as your house costs < £250,000 (25 years worth of 10k contribs) and b) derisk your investment towards the end by slowly switching it into cash over the last five years. I’m all for it, though it is a sophistication which would have been well beyond my 28-year old self."

    Yep – I would agree. It would also have been beyond me at 28 years old! Happily there are some benefits to getting older …. the S&S ISA is already up and running ;-)

    An extremely good article about house purchase and finance, well worthy of MSM [main stream media] but alas they would not use it as it shows too much common sense and a way out of the house price spiral that we are in.

    Like your Father I bought my first house, in the 70’s, just before houses became investments and no longer homes. Three things I believed started this spiral.

    1] The use of combined income became the norm, [1X your spouse + 3X your own] Surprisingly house prices jumped by almost what the average woman earned per year.

    This in turn led to a] the wife had to continue to work after a child was born, and b] this sudden rise led to greed when people saw homes rise, in some cases faster then the RPI or other investments FTSE etc.

    2] Next in the 80’s the sale at knock down prices of Council Houses [now called Social Housing] lots of people bought them using cheap loans in some case at less then the price of renting, but forgot things like maintenance, %rate hikes etc. This in turn led to the forced selling of these houses, in some cases the companies who lent the tenant the money to buy, rented the property to the then owner at a greater rent then what the council had charged.

    3] Then came the BTL Brigade, either people who had seen their house value rise and had a good proportion of equity in the house to borrow against, or substantial % of ex Council tenants who had bought their council house and then rented it out to some one else using the rental income to help pay for a house on a private estate.

    This led to a rapid rise in Housing Benefit payments, as people who could not now rent Council Houses [as most had been sold off] had to rent of private landlord at a greater rent, subsidised by Housing Benefits. This gave a further upward twist in the house price spiral.

    We have now achieved what I believe is the triple whammy.
    1] House prices are too high for first timers too buy, [median income £30-35k x 3 = £105k deposit £20k. £125k available for first time purchase] with average first time property buy at £150k.

    2] Rental price have soared due to lack of Social Housing and demand. Plus once you start to rent it is even more difficult to find the 10-20% deposit required.

    3] The rapid rise in Housing Benefit payments, this costs about 25% of what the Government raises in taxes. Plus 8% of what the Local Authority gets from Central Government in Housing Benefits must come from Local Ratepayers. This results in a hike in Local Rates.

    What is the answer, the solution is painful, a] freeze rents, b] enforce lending limits on mortgages, c] freeze housing benefits and d] a Property Tax of 1% paid by the owner, not the tenant, on all property empty or not. This will cause defaults on BTL property mortgages, cause Property Price Deflation, of 25-30% allowing first time buyers to buy. Also the Financial Institution who have now become the Property Owners would have to stump up 1% of the property they now own.

    If you have only one property and it falls in price, so what, so as everyone else’s, and negative equity only becomes a problem when you come to sell. After 4-5 years things will sort themselves out.

    I don’t know if you caught it, but I just watched the Panorama program on the poor in America:

    http://www.bbc.co.uk/iplayer/episode/b01c2y2b/Panorama_Poor_America/

    I cringe when I see a family living in a Motel room who had lived in an abandoned trailer when I see they used to rent a large and impressive house.

    The main thing is to remember the old adage: ‘pay yourself first’… if you’re not taking some of your money and putting it into building up an asset / capital base you’re very vulnerable. If you can afford a smaller place on a normal mortgage that is far better than somewhere on an interest-only. It can go wrong very quickly.

    It seems odd to me that houses can truly become overpriced, because if people stop being able or willing to buy them (and/or they buy them, but go broke such that the banks have to resell the property at the market rate), then people will have to lower the price to get a sale… right?

    Since we don’t accept homelessness, but have an expanding population and limited homes, it’s inevitable that a larger and larger proportion of the collective wallet should go on either paying for one’s own property or paying for that of others (through housing benefit).

    This will proceed until the cost of housing reaches equilibrium with the desire to breed, and the population stabilises. I guess the problem with this theory is that there isn’t a perfect market (for example, there’s no cost to having any number of kids when you’ll just receive more and more housing and other benefits).

    @Dave – have you considered the correlation between income and house prices… if house prices are going up faster than incomes then so is the proportion of income going on houses… hence there has to be a limit.

    This proportion relies very much on bank lending policies as to how much of your income you can leverage to buy a house, but it can only go so far… for starters there’s a limit at 100%.

    Come on Ermine. It’s true interest rate mortgages are far riskier and put to ill use by the unwashed masses (and their clients!) but the comparison with TV is silly.

    Over most 5 year periods and all but a smidgeon of 10 year ones, house prices have gone up. Over all terms of 25 year terms, they are way up.

    It’s even better if you think of it in real-terms — after 25 years, your debt to be paid off is probably going to have halved, even if you house price stayed put — which it never has before.

    In contrast, I doubt any TV other than a few Bakerlite prototypes have ever held their value for a year, let alone gone up in price.

    The comparison is a straw man I’m afraid old chap, IMHO. :)

    This is not to everyone – or even anyone – should be able to have them, though you may recall I’ve written on my blog about using them to fund investment, effectively.

    The impact of unrestrained credit on housing booms and busts is plain for all to see.

    In my view, the pudding doesn’t need to be over-egged.

    @Lupulco your analysis picks up a few things I hadn’t thought of. I don’t know how much BTL skews the market, but it does seem rough that BTL ‘investors’ get to claim tax back off the interest payments whereas ordinary grunts don’t. And I thought the council house sell-off was an outrageous piece of opportunistic vote-grabbing by Thatcher on a par with Brown’s huge rise in public sector non-jobs. Both of them have probably done lasting damage that it will take several decades to undo. We’ve never found a decent replacement for the council housing stock since the 1980s.

    @Dave, we also live at a lower density than we used to. Three families lived in the house I was born in, and there was a lot more shared occupation in the 1960s and 1970s than now. This doesn’t help us either, I guess this is hedonic adaptaion to more money about.

    @Rob, that program is truly scary :( Again the toxicity of people who have eyes larger than their wallets when they ‘buy’, shafted by a rapacious loan salesforce.

    @Monevator, hey, I used it as journalistic artifice to open the piece. Absolutely hands up and it’s a fair cop, I hope there aren’t any readers that truly equate a depreciating asset with a non-wasting asset ;)

    There are very few people who can use an interest-only mortgage correctly, particularly in their 20s and 30s, because the temptations are too big and, at least in my case, the level of financial awareness too low. You, and Anne above, are a long way to the tail of the bell-curve there, and in your case you do have a capital savings mechanism you could use to stand surety for the loan.

    Some financial products are safe in the hands of so few people that there’s a case to be made for not letting them loose on the general public. I’d say that the 1990s, where the mortgage company would take a charge on the capital savings mechanism, was a lax as we should go there.

    Interest only mortgages are lethal to the financial system when naive borrowers are combined with rapacious financiers. And so much money gets locked up in housing. I’d charge the removal of the need to repay the capital during the mortgage term for a lot of the house price inflation we suffered in the 2000s. It seems to reduce the amount you need to pay during the term by 1/3, but isn’t honest enough to declare itself as the rental agreement it really is. Even with hire purchase of the TV you usually got to pay some of the capital cost over the term ;)

    Don’t you have to deflate the house price in real terms too, BTW? Yes, the capital value of your debt does probably halve, but set against that you get to pay twice the capital value in interest over the term. Which you probably also have to deflate, so probably you end up paying twice in real terms for your house if you get to own it after 25 years, and about as much as the capital value if you end up owing that at the end of an interest only deal.

    Ah, but then you’d have to take into account that your ‘imputed rent’ had risen at least with inflation, and likely ahead of it.

    Basically a fixed interest loan is a lovely thing to set against a real asset that can be expected to at least keep its inflation-adjusted value, all things being equal.

    It’s why I’m occasionally be found pointing Rightmove at the provinces where prices have actually fallen. I’d *love* to get a fixed rate loan locked at c.4% for ten years.

    In case this sounds a bit clever and bell-curve stretching to some readers, they should keep in mind I was an idiot and didn’t get a loan a decade ago when I might have! ;)

    Off to polish my credentials and ponder setting up a secret society with Anne above. ;)

    Ah, I possible wasn’t as clear as I could have been!

    *my* Together mortgage *is* a repayment product. I actually wouldn’t be able to sleep if it was Interest only!

    IIRC, there was no requirement if you took the Interest Only option to prove that you were making provision to repay the capital at the end of the term. There was also no requirement to have life insurance to cater for a “worst case scenario”.

    Oh, and that £115K they were willing to lend me? If I had wanted the Interest Only product, that went up to over £120K! Scary, very, very scary.

    I worked for a multi-national financial services company at the start of the 2000′s, and we did mostly “sub-prime” stuff. I regret to say that I saw the economic disaster that was coming many years before the media started reporting it. And still people carried on borrowing at ridiculous, and unafforadable levels!

    I like interest only!

    But only if you make very sure to save on the side, or can take advantage of low rates to arbitrage savings or investments.

    The magic of compound interest is what I’m talking about ;-)

    Take a £150k mortgage at current rates and put £260 a month in an ISA and over 25 years at 5% tax free (I know rates are below this at the moment but assuming a return to historic norms) and you double your money, and can pay off the loan.

    I did this, and as I’ve raised my salary I’ve put more and more away, to the point I now have double my debt, but with a lucky low rate tracker I find I earn more in interest than the mortgage payments, so I’m not paying it down at the moment – much to Santander’s annoyance!

    It does take discipline though.

    TNT

    [...] Ermine waves a cheery goodbye to interest-only mortgages and explains why this is probably a good thing for consumers… http://simple-living-in-suffolk.co.uk/2012/02/why-the-demise-of-the-interest-only-mortgage-isnt-a-ba… [...]

    [...] the modern way to look at a mortgage is to take out an interest only loan, sit on your butt and whistle a dancing tune while the value of your house goes up. Voila, free [...]

    [...] is to go to the mortgage company and ask for a bigger mortgage, on the higher price, and preferably interest-only, if you please. That way you get extra money which is the difference between what your house was worth before and [...]

     

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