11 Apr 2014, 4:36pm
housing
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  • Mortgage income multiples and affordability

    One of the ways people are finding to pay more for houses is to switch from the historical use of income multiples to the new measure of ‘affordability’. The former gives the wrong answer, but the latter is great. Progress is good, but it’s worth understanding. When I bought my first house in 1989 mortgage providers would qualify a prospective mortgagee by asking how much did they want to borrow as a proportion of their gross salary 1. You’d typically get a mortgage of 3.5 times a single salary or 2.5 times joint salaries in the case of a couple.

    These sound low today. To the extent of being unworkable at current house prices for most people. It made sense 30 years ago, because Britain had just come off a run of double digit interest rates, personal taxation was much higher (the personal allowance nowadays is over a third of the median salary of £26,000, it was lower relative to salaries in the past). It is instructive to observe the relative proportions of mortgage interest and capital repayments over the typical 25 year period at 10% interest rates and the current ~2% rates.

    You spend much more time repaying capital at 2% APR

    You spend much more time repaying capital at 2% APR

    Compared to, say, my mortgage career at higher interest rates

    you pais a higher absolute amount relative ot the price of the house, and you pay interest for longer in the old days

    you paid a higher absolute amount relative to the price of the house, and you pay interest for longer in 1980s/1990s

    Which is much more like the canonical sudden rush of repayment towards the end that we used to know and love. When you tot up the total amount repaid, the 2% fellow pays 3*gross or 4* net salary, the 10% guy pays 7*gross or 9* net salary 2

    There’s clearly some case to be made for increasing the income multiple – provided that interest rates stay the same. After all, if we say I was paying the long-run British average of about 6% interest rates over my working life, then had I been earning the average wage, I’d have sunk 6*net/5* gross wages into my house 3. If it’s all different now, and low interest rates are here to stay, then it’s perfectly justified to sink twice as much into a house. In the end it’s what you pay over your working life that matters, and at lower interest rates the total amount paid is less.

    So bring it on, let’s run at twice the income multiples that were lent to people 25 years ago. That’s 7* single income and 5* double incomes. Now 7* median single income will buy you my house I believe, so the residual 10% gives you room to may the parasitic costs of moving and all the hangers-on.

    This isn’t recommendation or otherwise. Housing still rates as the greatest finance screw-up of my life, so what do I know ;)

    Thing is, it’s all different now are the most dangerous words in finance. Secular changes takes years to take effect. QE can’t last for ever. If you’re looking to buy a house as a first time buyer, you may not like Buy-to-Letters who are essentially front-running your heart’s desire. But say what you like about them, they’ve probably got a fair awareness of the mortgage market.It’s the oldest law of the jungle – when the big beasts start looking nervous it’s worth knowing why…

    Some of the BTL guys are running scared and fixing

    And it appears some of them are running scared and remortgaging now. Had I bought just three years later, the Ermine would probably be a buy-to-letter with a deep belief in the value of housing rather than still feeling it was a Weapon of Mass Wealth destruction – one’s early experiences with an asset class tend to be formative. However, I have recently seen younger BTLers come a cropper with the usual problems, underestimating the effect of voids, and underestimating the chavviness and lack of character of some tenants. As a tenant years ago I only saw the lack of character of landlords, but it seems to cut all ways. The residential housing market seems to bring out a particularly nasty streak in the British psyche – buying and selling houses is pretty horrible experience too. BTL landlords seem to need significant capital resources, and preferably a number of BTL properties to average these lumpy setbacks.

    It probably is a bit different now…

    But not as much as to justify a doubling of price to earnings. 4 or 5 time single, maybe. The double salary premium might go up a little bit more – mothers return to work quicker now than they used to. Let us postulate that it’s all different now. Mortgages are given on an income multiple of 7 times single salary, but it is required that you have a 10% deposit (ie 90% of the purchase price is advanced to you). Sounds fair enough?

    Let’s take a look at what your monthly repayments would be like, assuming you’re on a standard variable rate, ranging from the 1% it’s around now to the 14-16% at the high-water mark of what I saw in my mortgage career.

    your mortgage payments as a function of annual interest rates

    your mortgage payments as a function of annual interest rates

    at 15% you’re paying out more than 90% of your net pay in mortgage. Nothing left to pay bills, council tax and you had better become a breatharian or start scavenging food from bins like Top Cat. Note that you don’t have to see sustained rates like this for several years. Just a couple of years of that can slaughter you unless you have significant savings behind you. It all boils down to the usual question.

    I’ve been there – well less than that, but I’ve spent more than half my net pay on the mortgage.

    If you’re going to start down that track then at least know what the enemy looks like. This has nothing to do with negative equity, it’s straight interest rates. You need to either have savings, live more frugally, or get a payment holiday. Those savings need to be about two years of running costs. Then it’s a fair gamble, because after two years of 15% interest rates Britain will look very different. The general misery would be such that some government would probably have to do whatever it takes to reduce them, or start dropping money from helicopters 4.

    an old idea from 1969

    an old idea from 1969

    Your aim as that homeowner is to be still standing when all the people around you have been repossessed.

    It can be done. But it’s rough being the house between two evicted properties. You do start to wonder when it’ll be your turn. It’s no fun at all…

    Frugality is the solution there; by definition. If you were earning more then your earnings multiple would be lower. It’s not something that sits easily with expectations now. And God help you if you have any other debt.

    Income multiples will matter again if interest rates rise to historical norms of ~6%. Mr putative 7 times net  income multiple will be paying ~50% of his income on the mortgage.

    Methodology

    This spreadsheet. I calibrated it against this calculator and derived the formula from Francis Webb’s Mortgage interest calculator template. 5

    I’m done with property now. Even after 25 years the thought of residential property as an asset class brings me out in hives ;) Good luck all and be careful out there.

     

    Notes:

    1. The rationale for gross salary was Mortgage Interest Relief At Source(MIRAS) allowed you to pay the interest from pre-tax salary. Barmy, I know, though notably the United States still has mortgage interest on residential property as tax-deductible I believe
    2. I have assumed the 3.5 times multiple applies to net salary since you don’t get MIRAS any more
    3. I earned more than the median wage for nearly a lot of my working life, so this isn’t that bad. However, I am looking for the scale factor, the old mortgage income multiples were workable, many people have paid off their mortgages from then
    4. Milton Friedman, 1969 The Optimum Quantity of Money And Other Essays
    5. I regret to say that I didn’t bother trying to understand the function, simply copied it and tested it against Monevator’s calculator. It was too nice a day to wrangle that sort of detail, so as long as there isn’t s systematic error across both sources it should be right :)

    Just a thought — with your terror of inflation and a Weimar-zation endgame for the UK debt situation, property and indeed a big mortgage has some unmentioned upside, in that the property price should track the inflation and the inflation should vapourize the debts.

    Then you just need to ensure you’re earning sufficient suitcases of £1,000,000 notes to keep the man at Lloyds happy in the interim. :)

    (Note: Not a likely scenario in my view, but mentioned for completeness! ;) )

    @Monevator Being retired for a year and a half has thinned out some of the fearfulness ;)

    However, if we’re gonna go down that line of thinking, in such a hyperinflation I would be surprised if the financial system survives, or preserves information across the intercession. Weimar at least preserved information in paper form. You need non-financial investments and human connections to hold the line.

    In the confusion, however, debts can be sold to unsavoury fellows with dubious methods.

    Modest inflation OTOH (<50%) is great for mortgage holders. The 1970s inflation allowed my Dad to pay off his mortgage earlier in his working life that it took me, though I had a better paying job and no children. Betting a leveraged claim on my future income on that, however, invokes that Clint fellow again!

    Your graph of interest payments at 2% looks like a great deal. Tempting if you’re stuck in a rental flatshare crack-den, with a couple of nutcases, paying well over the odds. You could say that house prices are reasonable (I’m struggling to get that out on the keyboard), in that mortgage costs, as a % of average net salary, are not too far off the historical average. The big fat elephant in the room is mortgage interest rates are way out of step with historical average. Not just a bit out of step, the lowest for 300 years out of step. BOE base rates are usually in line with inflation but a tad more, so by my fag packet (I don’t smoke, can anyone afford to) calculations, mortgage rates now, should be around 5-6% (corrections welcome). So if someone is borrowing 4,5,6,7x salary, or joint multiples of their choice, and the mortgage looks affordable, I’d err towards checking out how affordable it might be at a normal rate, or perhaps one a few notches higher(courtesy of Ermines Graph 3). It’s also worth giving a nod to all the government props in place since the (mini) crash of 2008, to prevent the market finding it’s free market level relative to income. Banks told to back off on repo’s. Strugglers swopped over to IO mortgages. Funding for Lending, Help2Buy1. Help2Buy2 (is Help2Buy10 where they just lend you a 100% deposit?… maybe that’s Help to Rent who knows). So providing you’re confident none of these props are going to be withdrawn and interest rates won’t rise, the foreign funny money won’t find a better place to park itself, and your financials all stack up, then fill your boots at the highest multiples you can get your hands on. Tell it to Clint too.

    I’d like to think other peoples debts aren’t my problem, but the rubbish rates on ISA’s tell me they are. All I hope is, that before diving up to the gills in debt, people at least spend 5 minutes on a calculator. I’m surrounded in The Firm by young(er) pups piling into property. What shocks me most is if you’re earning sub 40k, and somehow in a half a mills worth of residential and IO BTL mortgage debt, don’t pop your head over the desk divide and ask me what yields and voids are, and look surprised when you find out mortgage rates do go up. Christ. Anyway, what do I know, I’m not privy to new schemes to manipulate the market, so perhaps I’m completely wrong, and I’ll have to lower my expectations of my future home. The nights of good sleep are well worth the gamble of going short on this one.

    Here’s my high tech equation to sum it up: High multiple salary mortgages + lowest mortgage rates ever = stupid.

    12 Apr 2014, 11:39pm
    by Neverland


    @Monevator

    Will inflation be allowed at a time when so many of the electorate are pensioners?

    Japan and Germany indicate not

    I wonder how you feel about multiples when there’s no mortgage. Meaning, if you’re not going into debt to finance the house, how much should you pay for the house relative to your salary.
    You have some sort of protection in the sense that no one is taking the house away from you even if the skies are falling and the interest rates are moving skywards, but at the same time, you will be quite unprotected for all the other risks that you mentioned – divorce, job loss, etc.

    @Starla

    I’m surrounded in The Firm by young(er) pups piling into property. What shocks me most is if you’re earning sub 40k, and somehow in a half a mills worth of residential and IO BTL mortgage debt,

    Yikes. The best of British luck to them! It may work – London is a special case, I suppose, and it’s all different now. BTL tends to be an old man’s game or one for well-capitalised specialists who understand the lumpy nature of the costs and have an answer to that. I’ve seen younger folk get had by the sudden surprise of needing to carry on paying the mortgage in voids – what did they think would happen!

    @raluca it’s the leverage that is lethal with mortgages because it amplifies the gains and losses. If you are a cash buyer this is absent.

    Say you have an income of £10,000 net and buy a house at a 7x individual income multiple, so your half share is £70,000 – the whole house is £140,000. I’m ignoring the 10% deposit consideration because it isn’t relevant. House prices fall by 50% nominal (this is twice the fall that I experienced at the low-water mark)

    You split up with your partner. Your half of the now £70,000 house sells for £35,000. You are now out there looking for another house, let’s say of the same standard despite that fact you are single, that now costs £70,000 in total (it would have cost £140,000 earlier, the same as the house you originally bought with your partner).

    You come along with a 50% deposit (£35k) and are looking to borrow on an income multiple of 3.5 times salary. You will have very little trouble getting a mortgage. If house prices then rise to the original value of £140,000 you now own the whole house less £35,000. If you find love and sell half the house to a new partner for £70k, pay down your mortgage and have £35k to play with :)

    A lot of the hit of job loss is that you lose your home because you can’t service the debt, and if you suffered negative equity the debt still hangs around your neck or you go bankrupt.

    Without that issue, the scale of the ask is so much less. It’s simply an unleveraged bad investment.

    @ermine, were you inspired by this: http://mainlymacro.blogspot.co.uk/2014/04/house-prices-and-secular-stagnation.html that timharford posted on his twitter feed? I was shocked, in particular, by the 90% of income going on mortgage payments in the ’80s at the height of the boom. Of course, as you know I got “lucky” and bought after that with trifling 11% interest rates.

    I think you make a case though, as does mainlymacro, that income multiples can’t be viewed in isolation, nor can interest rates. Both are part of the, complex, equation.

    Current, esp. London, prices seem high and weird, but I suppose if I was to go back x years and order two pints of beer in a pub and pay with a £20 note I would get some very odd looks!

    @starla – you never know, they might be using leverage in a really smart way, 5% of their own money (or a loan/bond/security) and the rest in low-interest servicing. Maybe they’ve all been reading some of the “Rich Dad, Poor Dad” book that recommends such a strategy. [Not, I should point out that I do!]

    […] the price range, we could have easily afforded the mortgage payments but it’s not all about affordability! 2) It actually felt a bit too big for just the two of us, and I could imagine the bills being […]

    @ mister squirrel – while it’s entirely possible the new entrant amatuer BTL’ers at work may be smarter than I give them credit for, it’s unlikely. This weeks revelation was that you do have to declare income and tax to the IR, as a collegue found out through the post. Fortunately (or not) it forced them to calculate that they’d made a clanger of a loss. A sub 3% yield may be ok, with a dash of HPI, as long as emergency interest rates are low and mortgages are cheap. You can do all sorts of “smart” leveraging stuff then. The problems rack up when the cost of borrowing returns to normal. It’s all too roulette wheel, black or red, for my liking.

     

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