Tighter Lending? Interest-only mortgage timebomb? That was set ticking years ago

Shock across the nation as our biggest building society, the Nationwide, KO’s the interest only mortgage. Apparently it means there’s an interest-only mortgage timebomb that’s just gone off! Oh No! The Daily Mail’s Simon Lambert tells us

Do you have an extra £400 a month spare to spend on your mortgage? That is the kind of the potential rude awakening that awaits millions of homeowners with interest-only mortgages the next time that they want to move home or remortgage. Many of them will be blissfully unaware that their personal interest-only mortgage timebomb exists.

Well, no. Let’s reframe this a little bit. Joe and Josephine First Time Buyer wander into ther friendly local building society to see the manager, Mr Wolf. The conversation goes like this

JJ: we’ve seen this lovely little house and we’d like to buy it with some of your money, please.

Wolf: okay, we’ll take a look. So you want to borrow £250,000 over twenty-five years you’ll pay us back the money and we’ll have to charge interest on it I’m afraid.That will be £10,000 capital and £12500 interest at 5% each year 1. How do you feel about paying £1875 a month for your house?

JJ oh that’s far too much. Here, how about we just pay the interest?

Mr Wolf thinks  Interest-only? pleasure doing business with you, Josephine’

Wolf: oh, okay then, that’s just £1041 pcm by then

JJ: fantastic, where do we sign up?

furious scribbling of documents. JJ leave with smiles on their faces. Just as they turn to leave, they say

JJ: Thank you so much Mr Wolf!

Wolf: And thank you, JJ. I’ll have retired by then, but my successor will be along in 2037 to pick up the keys to the house when we take it back. Great doing business with you. [bares rows upon rows of pearly teeth in a smile]

Therein lies the rub. If you can only afford the house of your dreams by just paying the interest on the loan, then your dreams are too big for your pocket. You can’t afford the house, and in practice your shortfall is about half.

Of course, this isn’t how people think about it. Typical thinking is epitomised in this Torygraph article about Tough New Mortage Rules to hit First Time Buyers and borrowers in their 50s. What part of ‘home owner’ does the Torygraph not get? To own something, you pay all of it, not just the interest on the credit card used to buy it.

Here what they have to say about one of the more pernicious pieces of financial engineering over the last decade or so, the interest-only mortgage

Because they have lower monthly repayments, these types of loans have in the past helped millions get onto the housing ladder.

There’s a perfectly good alternative way of looking at this

Because they have lower monthly repayments, these types of loans have in the past helped millions to overpay by about twice for their houses, which they will never get to own.

Doesn’t sound so nice put that way, does it?It also fundamentally builds in a deep need for house prices to rise nominally. Not in the abstract I feel richer because my net worth has risen way, but in the ‘Aaargh I owe more money than I’d get if I sold up‘ way.

Now for those hard pressed 50-somethings for whom the Telegraph’s heart is bleeding, because, shock horror,

It will pose difficulties for people who are in their 50s wanting to take out a typical 25-year mortgage. For example, a 55-year-old would struggle to obtain a home loan because it would not be paid off until they were 80.

Well, er, yes, I mean the obvious question has to be asked of Johnny-come-lately.

You should be owning your house free and clear, not getting a 25 year mortgage at your stage of life. Two score years and ten + 25 into three score years and ten won’t go!

A mortgage is a way to place a claim on the value of your future work to buy something expensive now.  The Jobcentre doesn’t have many outlets six foot under. You’re a rotten risk compared to a 30 year old, because over the next 25 years you’re more likely to die and you’re much more likely to lose your job permanently, plus you don’t exactly show an awesome track record of saving. That’s forgivable in a 30 year old but not in a 50 year old. So thanks but no thanks, we won’t be lending you any money!

If I wanted to take out a mortgage now I would damn well expect the mortgage firm to ask me how I was going to repay the interest and capital within ten years or less. If I couldn’t afford it I’d expect them to tell me to get on my bike. And I’d expect them to demand life insurance to discharge the mortgage should I peg it in the duration.

As you get older a mortgage simply isn’t a good product for much of the equity in your main residence. If you need one, you aren’t rich enough to be able to afford to live there, unless you can pay a 10 year repayment mortgage. If I want to buy another house I either use the accumulated equity in my current house by selling it, adding cash if I upgrade, or I pay cash for it or I secure a mortgage on it as a financial investment like a buy to let mortgage, but then I don’t get to live in it.

stick half your working life into ten thousand or so of these, or…

But – but – but it’s so unfair! I can hear the wannabe homebuyers of the country thinking. This actually will work in your favour over the next few years. It will stop all those other jerks offering way over the odds for houses using their interest only mortgages. That will reduce demand at current prices, and the sellers will have to eat crap and drop their prices. Which means less of your lifetime earnings will go into housing, and more into foreign holidays, and meals out. It’s not all bad, eh? What would you rather have, 25 years of sun sea and sand or a pile of mute bricks soaking up your dreams?

alternatively add 25 years of beach holidays to the mix by overpaying less?

So not only are current buyers sinking more of their lifetime earnings into houses, they don’t get to own the damn things at the end! That’s the ultimate tragedy of the commons – it’s nuts from a collective viewpoint but rational from a individual viewpoint, because everybody else is at it. It a rough deal and It.Must. Stop – so good on the FSA for finally putting an end to this racket 2 Yes, the buyers from 2006 and 2007 will get to eat the crow, just like I did after buying in 1989. The only way for prices to go up as fast as they have done over the past 20 years again is if we start to have Japanese or Swiss-style intergenerational mortgages. Let’s hope the regulators aren’t asleep at the switch if that idea raises its ugly head, eh? The level-headed Swiss are probably more competent to handle that sort of thing, the gnomes didn’t get to watch over the assembled loot of the rich for generations without showing some track record of financial nous. It still seems barmy to be, but most nations have at least one widespread bizarre national quirk that looks mad to the rest of the world.

 

UK home ownership. From Nationwide, http://www.nationwide.co.uk/hpi/historical/Feb_2012.pdf

In Britain before Thatcher, a lot fewer people owned 3 their own homes (50% as opposed to todays ~70%) 4, and they invariably took out either repayment mortgages or purchased an investment that was intended to repay the capital at the end of term in combination with an interest only loan, and the building society took a primary charge on that investment. I was shocked when I moved in 1999 and the building society didn’t ask me how I was intending to pay the 40% extra that wasn’t covered by the endowment I had at the time. I switched the mortgage to a 60% interest-only (covered with an endowment) and 40% repayment mortgage. Incredulously, I asked the mortgage adviser what he expected to happen at the end, to which he replied most people want to keep the payments down as much as possible.

Well, I didn’t. I intended to pay my debts thanks all the same, and had to kick up a fuss to do so. There are a few sharp people around who know how to play an interest only mortgage. They are very few and far between, and the interest-only mortgage is a Weapon of Wealth Destruction in most people’s hands. There are two ways that it destroys wealth. One is people getting repossessed if they stretch themselves too far, but there’s a much more insidious way it destroys wealth.

It lets many people overpay for houses, bidding the price up too much

Houses are effectively sold by auction, because they aren’t easily comparable or interchangeable with others. If you can borrow interest only, you can ‘afford’ to bid roughly twice as much as if you actually had to pay that money back over 25 years. Ergo, the price of houses goes up about twice. This goes for other means of artificially supporting house buyers. Every single attempt by governments or other agencies to make them ‘more affordable’ has simply jacked the price up to compensate.

This benefits the providers of capital, ie the banks and building societies because they get to lend twice as much money. The higher price helps housebuilders, but all this doesn’t help the borrowers one bit. Of course banks were up for interest only mortgages – they got to lend a lot more money that way!

We had a much less dysfunctional housing market before Thatcher got in there and started buggering about with it. Those who couldn’t afford housing lived in council housing if they had children and lodging or bedsits if they didn’t, and a small proportion bought a house using a mortgage.There was a lot wrong with council housing, but in general it worked for a much wider range of society than social housing seems to now.

Britain is a small island with a lot of people in it. The sad fact is that not that many people can really afford to truly buy a house over a working life. The 1970’s ratio of 50% is probably on the high side. The even sadder fact is that all the muddling with the housing market has jacked prices up so much that an even lower percentage of people will probably get to own their houses in future.

The interest-only mortgage timebomb started ticking roundabout when I remortgaged to move, when mortgage providers let people get out of the door without having a repayment strategy in place. But we can’t just place the blame on the providers. The borrowers have to take a teeny bit of the blame too, for not asking themselves the question I asked myself in 1999. That question is

how am I going to pay back the money I have borrowed, 25 years after I sign up on this dotted line?

It has been surprisingly possible to achieve this in the past, probably because mortgage companies only lent money to people they expected to be able to repay it, rather than indulging in NINJA loans.

homes owned outright almost at parity with ones on a mortgage

I was surprised to discover this graph  5 showing the percentage of people that own outright, compared to ‘owning’ with a mortgage. I hadn’t expected 50% of owner occupiers to be mortgage free. I suspect this will be lower in 25 year’s time when Joe and Josephine approach the end of their working lives, precisely because of those interest-only mortgages. The bank will have made a shedload of money, though not as much as they lost lending money to Americans without any money. And JJ still won’t own their house, though they will have the warm glow from feeling they were worth a lot of money way back when. One of their best hopes is this fellow

With a bit of luck he’s devalued the currency enough that the capital cost of their house is worth the price of a Mars bar and a pumpkin latte.

They might wish to bear in mind my experience as a cautionary tale, then. I stupidly paid way over the odds for a two-up-two-down in 1989. Sticking a sly paw into Merv’s back pocket to borrow the inflation calculator the Ermine dicovered that the inflation-adjusted value of this amout in 2011 was over two-thirds of the price of my current house. Now the capital doesn’t appreciate on an interest only mortgage, but even the original capital amount is a third of the price of my current house. Zoopla tells me it is about half the price of a house of the same type in the same road as the one I owned. Yes, inflation is your friend, but not as much as it was in the 1970s.

Oh and Mr Wolf? Happily retired and studying the phases of the moon with his telescope.

Notes:

  1. I have brutally simplified the complexities of mortgage interest calculations, it’ll do for this
  2. Unlike in the past when lenders would take a primary charge on an asset this has many loopholes. Lenders would be required to check at least once during the term of the loan that the savings pot its still in place. I am happy to say I back a borrower for a month during the check with the contents of my ISA in return for a fat fee and the insurance premium, and I am sure there’ll be others providing the service on a commercial basis ;)
  3. In the UK people say they own their houses even if they have a mortgage. I personally believe I only owned my house when I discharged the mortgage, but nearly all stats use the more general used sense of owned by the finance provider on behalf of the borrower
  4. about 50% in the mid 1970s as compared to ~70% now
  5. DWP

@ Ermine – have you factored in that J&J will both still (maybe?) be working until they’re +70?
Also a higher %age of J&J’s will be inheriting property than in our day.
Still, the last of interest only mortgages can only be a good thing.

I am seriously shocked by the number of people who are 50+ and taking on mortgages. I was talking to a colleague – an educated and (I thought) sensible person – who coolly informed me that they and their partner (both mid 50s) had felt that they were ‘far too financially comfortable’ and so had decided to buy a new house with a large mortgage on it. There are just the two of them, no obvious need for a bigger house.

To say I was surprised would be an understatement – why in God’s name were they not saving and investing all their surplus income? Although both were working, they could not honestly say that their jobs were bullet-proof (few can, these days).

What shocked me most was that this colleague clearly felt that this was a prudent financial choice for them to be making. I was entirely lost for words (an unusual situation, as my husband would no doubt tell you).

Perhaps they had opted for an interest-only mortgage? After all, what could possibly go wrong…

They certainly will have to work until they’re 70+ if they get an interest only mortgage as that implies either remortgaging or “trading up” at some point.
I think an interesting point is that having an interest only inflation isn’t as much your friend as having a “classical” mortgage where your principal is reduced via your payments. Also with a normal mortgage the amount of interest you pay over time reduces as you repay your principal-I assume that with interest only that amount stays the same(sorry being a foreigner I’m not that familiar with the concept, but thats how I imagine it works)? Depending on the interest rate you pay – even if its just the rate of inflation – after 25 years you will still at least pay the same amount (in real terms) in interest. If you repay the principal your interest payment goes at least down accordingly…

I think you’ll find that they still do interest-only mortgages…

It’s called renting…

I am also shocked at the number of over 50s still taking on new mortgages! Do people seriously not realise that paying the interest is just like renting – they owe nothing. Fair enough, there is appreciation potential, but equally there is a risk of the opposite happening!

If you can only afford the house of your dreams by just paying the interest on the loan, then your dreams are too big for your pocket

I think you said it all…

@Romany – the longer working life improves things by giving inflation more time to erode the capital sum. However, people often use(d) interest only mortgages to upgrade on the housing ladder. They’ll still never own their house, and upgrading resets the capital owed to a higher level :( It’s true that people will inherit younger because social pressures mean average childbearing age is is rising, though longevity is also rising to cancel some of that out!

@Jane, that’s bizarre. After all, what has this couple got against taking more lavish holidays, at least that doesn’t permanently weaken their situation. And it might be more fun! Having said that, I did notice in my ex-colleagues of a similar age a real belief in the value of property as an asset class. Some had second homes in places like Spain, and they generally had a lot more net-worth in property than I do. And sometimes the mortgages to match!

@Greg, you guessed right, interest-only does just pay the interest, though inflation does help you a little because your pay goes up with inflation hopefully, but you are still paying x% or the original value that inflation has eroded. A repayment mortgage pays down the capital in a sudden rush at the end – I copied the chart in this post from the excellent Mortgages Exposed website. This is a mathematical result of keeping the payments the same over the 25 years.

@Rob that’s wickedly dry wit ;)

@SavvyScot I believe many people don’t realise that, and yes it is shocking! Ever seen the movie Idiocracy? A house is the second biggest purchase most people make in their life and for them not to realise they’re only paying the interest is nuts. this article asserts that there is about £100bn on interest-only and just 25% of IO borrowers have made any attempt to pay down the capital. The other 75% are living in La La land, particularly if the FSA changes ease or hopefully reverse house price inflation. I’ve paid down an interest only mortgage on a house I sold for less than I paid and it’s a bloody awful experience tossing thousands of pounds into a black hole. However, at least I had the capital I built up in the endowment to help me with the next one, these poor saps won’t have that :(

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