[First published in 2009)
“The key factor behind the doubling in average house prices since 1996 has been the shift to a low interest rate environment… Today, £5,000 of annual mortgage repayments buys £120,000 of mortgage debt, assuming a four percent mortgage rate. This is almost three times higher than the mortgage that could be afforded at 11.5%, the average mortgage rate over the 1980’s…It is no surprise therefore that gross mortgage lending is also rising at record levels.”
Market Comment: FPDSavills, Back in the Day
Many commentators today argue that, as most people borrow money for a house rather than pay in cash, comparing the price of houses vs. earnings, inflation, or rents is misleading. They dismiss how much a property actually costs as irrelevant, going on to say that it only matters how much it costs to borrow the money to buy it. They claim that the true measure of affordability is solely the cost of servicing the mortgage payments – if the initial monthly payment is a high percentage of take home pay then the house is relatively “unaffordable”, if it is a low percentage of take home pay then the house is relatively “affordable”. Simple, no?
By this “affordability” measure UK house prices are not at their peak. The current “affordability” of property is driven by the unusually low interest rate environment. The historic peak of mortgage “unaffordability” was in the late 1980s, when interest rates were 14% and nearly 60% of take home pay was needed to pay the monthly mortgage payments. As of the end of 2005 just over 40% was required. So mortgages are cheaper, right?
Unfortunately, regardless of the metric used, it isn’t that simple. The “affordability” as defined above and used regularly in the media is an overly simplistic snapshot in time. It is a wheeze that gives no indication of how it actually feels to make monthly mortgage payments over the length of a mortgage, nor how quickly you might be able to afford to trade up. Declaring a mortgage as “affordable” because the 1st monthly payment of a $500,000 debt is a relatively low percentage of monthly salary sounds attractive. But a mortgage is for life, not just for Christmas. When you commit to a mortgage you are not just committing to the first few payments, but to a complete set of payments over the entire mortgage term (the term mortgage originally comes from “death-pledge” – a lifetime commitment). This matters. In fact, how those payments vary over time actually matters more to your future financial well-being than the initial payments. Not only that, but with millions of debtors in the economy it has a huge aggregate impact at a national scale.
This is actually no secret – the basic premise is very well known. The banks and lending societies that sell mortgages know that the most important measure of worth is the entire stream of promised mortgage payments – remember, your payments are their profits! But banks don’t always want to wait years for that money to be paid, they prefer a profit today. So in recent years they have packaged up hundreds or thousands of these mortgages into complex structured finance products, pricing them based on the total repayments committed to and the perceived risk of the borrowers. In this way the agreed payments represent future revenue streams and profit that investors will pay for today. This practice enables the lenders to make immediate rather than deferred profit for their bottom line and provides yet more money to lend again. This was one of the big stories of the early 21st Century, during which time it was the market to be in – in 2003 the market for mortgage backed securities was $9 trillion in the US alone, and this doesn’t account for and the derivatives that rely upon them. All of this hangs off the total amount you have committed to pay.
In contrast, the “affordability” described and used by the media is more realistically called “initial monthly cashflow”. This matters because it can make a prospective mortgage an attractive tease, but an appreciation of the impact of inflation and earnings growth is required to fully understand why all is not what it seems.
Real vs. Nominal Interest Rates
Whilst interest rate changes regularly make the news, concentrating solely on the headline rate can be very misleading. The true lifetime affordability of a mortgage is actually defined by the headline (or nominal) interest rate in combination with the inflation rate and the mortgage length. Banks, financiers, and businesses all know the importance of inflation and term, but unfortunately most of their customers do not.
Anyone who lived through the 1970s will remember why inflation is important. In a high inflation economy the price of everything goes up rapidly. In the mid 1970s the rate of inflation was up to 25% a year, meaning that the cost of your shopping basket went up rapidly & the money in your pocket was worth less and less every month. Fortunately your wage would also rise, but this would often only happen yearly, or at best twice a year, and even then it would commonly lag the most recent price increases. So for many years it felt as if the cost of living was rising beyond people’s wages. People felt quite poor. This is the common perception of inflation. Whilst for many this understanding is fairly obvious there are also more subtle reasons why inflation matters not just to the weekly shop, but also to how it feels to be in debt and to pay a mortgage at different times.
Real Interest Rates Matter
Here’s a quick test. If you are borrowing $200,000, is a 3% or a 10% interest rate better? The obvious answer is that the 3% rate is better, but in actual fact you are missing some crucial context for the decision. If the question turns out to be a comparison of different time periods (or different countries) and the actual inflation rate is 1% for the 3% loan and 20% for the 10% loan then is your answer the same? It shouldn’t be. Paying a 10% interest rate on a loan is no problem if your wages are rising at 20% per year – you can easily pay off the yearly interest and have money left over just from your inflation linked pay rise. It’s almost free money. In contrast, it is much harder to make the payments on the 3% loan if your wages are only growing at 1%.
The real interest rate takes into account how it feels to make the debt payments over time. It is calculated by taking the headline, or nominal, interest rate and subtracting inflation. In the example above the real interest rate for a 3% loan in a 1% inflation world is 2%, whilst the real interest rate for a 10% loan at 20% inflation is -10%. The smaller (or more negative) the number, the easier it feels to pay. Negative real interest rates are in effect free money for the debtor.
An understanding of real interest rates also highlights another possibility – it is possible to have different headline interest rates with the same real interest rates if the inflation rate varies as well. I.e. a 7% interest rate at 5% inflation, or a 20% interest rate at 18% inflation, or a 3% interest rate at 1% inflation all have real interest rates of 2%. For a given amount of money, making the total long term payments of each of these loans will feel similar. It is their upfront costs, or initial cashflow requirement, that are different, and it is this that makes one mortgage seem more affordable than another. However, because the total amount paid feels the same for a given real interest rate it is not rational to bid up house prices just because the nominal rate, and thus initial cashflow requirement, drops
This understanding matters. If someone told you that in 1976 interest rates were 16% you might be interested to know that inflation was nearly 20% at the time. The real interest rate was actually negative. In contrast, the interest rate in 2006 was 4% whilst inflation was officially 2%. Despite initial appearances it was actually better to borrow in 1976.
Affordability vs Cashflow
The distinction between affordability and cashflow is crucial. It is this difference that confuses many people into thinking a ‘70s mortgage is harder to pay than a modern one. Paying the 1st years payments on a 20% loan will take a large percentage of your pay during that year. The cashflow will be tight and most of your money will go towards paying your mortgage. However, once you have your first pay increase, which in a high inflation world will be substantial, it will become a lot easier. The cashflow eases, and becomes easier still after two years, and even easier after three. So whilst the initial cashflow is tough, the affordability over the lifetime of the mortgage is actually very good.
The experience of the 1970s has even affected our culture. Most people who have started out in the housing market since the year 2000, or are hoping to start out today, have parents who bought their homes in the ‘70s. High inflation and high interest rates during this period meant that many home buyers of the time will remember that they had to make significant sacrifices and experienced very tight finances for the first few years of their mortgage. If you are borrowing money at 15% per year you can only borrow a relatively small amount if you want to have a chance of making the first year’s payments – the initial cashflow. But as shown, if your wages are rising significantly every year then it gets easier quite quickly. This is exactly what happened during the ‘70s. People took out mortgages with challenging cashflows in their initial years, meaning that they felt poor, but inflation and wage increases rapidly improved their lot. This meant that after a few years their debt was actually a very manageable percentage of their salary and their cashflow had considerably eased. At this stage they could choose to trade up to a larger property or simply have more money to spend. The concept of a housing ladder was born.
Another example can be taken from the peak of the last “boom” in 1989 and 1990. At that time UK interest rates were between 13% and 14%. It was within this context that the all-time record first year mortgage payments (cashflow) were eating up 60% of take home salary. However, at the same time inflation was running at over 10%. This meant that if everything had stayed the same throughout the early 1990s it would have been approximately 10% easier to make the payments for each subsequent year of the mortgage (as earnings approximately track inflation). Thus it would have taken just over three years of a mortgage for the payments to drop from their record 60% to just over 40%, even without any change in interest rates.
A low inflation environment is quite different. Today, people’s wages are not rising nearly as quickly as in previous years and real interest rates are actually not that much different from previous generations. But because the initial cashflow is much easier to pay people have declared that they can “afford” a more expensive mortgage. They are convinced that they can “afford” more debt. The experience of the baby boomer generation in 1970s and their hand-me-down learnings suggests that the right thing to do is to pay as much of your earnings as you can afford to buy a small property, as things will get better and you will be able to trade up quickly. In aggregate we have taken this 1970s strategy and applied it to today. Unfortunately, what they don’t tell you when they say housing is “affordable” is that low inflation lets debts linger longer. As wages are not increasing quickly the debt payments stay high as a percentage of salary. The initial payments may be no harder than in previous generations, but without the debt eroding benefit of inflation the later payments are considerably higher. It’s important to be clear about this: a new debtor today will pay much, much more over the life of a loan than ever before, even though the initial cashflow “affordability” tease looks better. As a result new mortgage debtors will have to work harder, for longer. Not only that, but they will find it harder to trade up as quickly as previous generations.
This can be shown graphically. The graphs and examples illustrated below show that for a given debt, the same real interest rates (headline minus inflation) result in the same total payments over the length of the mortgage. The effect of lower inflation is to allow lower nominal rates. Whilst this makes the early payments cheaper (easier cashflow) it also makes the later payments more expensive. It’s important to remember that when you sign up to a mortgage you are buying the whole curve, not just the initial payments. Hopefully this alone illustrates why it is not rational to bid up house prices when nominal interest rates fall. They are not more affordable. By bidding up prices to the maximum of your ability to meet the initial mortgage payments as suggested by real estate pundits pushing “affordability”, you will pay as much in the early years as in a high interest rate environment, but much, much more in the later years than any other generation.
So what should have people have done? The counter intuitive, but rational, thing to do during low nominal (but similar real) interest rates is to pay the same for a house as you would with high interest rates but make use of the cheaper initial payments and better cashflow to save and invest for the future so that you can more easily pay the more expensive payments later. Of course, this is not what we’ve been trained to do. Humans are not natural savers and the experience of the 1970s means that we are prone to take a high inflation strategy (“early payments are always high – but it gets easier”) and apply it to a low inflation world. This is a mistake
The Implications of Mistaking Cashflow for Affordability
Mistaking cashflow for affordablity has implications. It means that those buying today will have less spare money 5 years after the start of their mortgage than previous buyers, and much less spare money 10 years into the mortgage. As a result, trading up will be much harder too – effectively the rungs of the ”property ladder” have moved farther apart. Those that max out their cashflow by buying a one bedroom flat will find it’s much harder to get into that 3 bed house than they thought it would be. It is actually less affordable than they thought, and there will be a lot of disappointment.
Unfortunately, that’s not all. It’s not just about trading up. Higher debt payments that linger for longer mean that borrowers cannot consume as much in the future when compared to previous generations. If you’re paying high mortgage payments in the 3rd, 5th, or 8th year of a mortgage then there’s clearly less spare money to spend on cars, holidays, houses, & televisions. Also, if you have taken out a significant debt that puts you into mortgage stress (>33% of gross earnings) then you will be under that financial stress for longer than ever before. Low inflation doesn’t just let debt linger longer, it lets financial vulnerability linger longer too.
This means, at a minimum, that there has to be less consumption growth in the future than in the past. As private consumption is a large percentage of the UK’s GDP then this will affect the entire country’s growth figures. Additionally, as mortgage payments will remain a large percentage of salary for longer the new generation of mortgage debtors will also be more vulnerable to financial shocks for longer. It is hard to predict what will happen in the next couple of years, let alone in 10 years, but in a low inflation world the borrower needs to think much longer term. Effectively the event horizon has stretched out from a couple of years to a decade. This may be a particular surprise to those that have committed to large debts and then want to start a family. Unexpected unemployment or personal tragedy will also have a greater impact on those still struggling with high debt, curtailing their spending or in a worst case meaning they will default on their mortgage payments. In aggregate, millions of debtors in this position will increase the vulnerability (and thus volatility) of the broader economy. Low nominal interest rates plus lax credit standards equals more volatility and vulnerability, not sustainability.
This all adds up to a subtle but very important point. By taking out a large mortgage today in a low interest rate world borrowers effectively commit a large percentage of their future earnings (and labour) and bring that spending potential forward. This is a huge amount of money that is effectively imported from the future to today, funding current consumption levels and supporting the elevated house prices. Of course, the mortgage borrowers aren’t the winners – they don’t get to keep the money. They give it to a home seller, who will then perhaps also take on more debt and buy a property farther up the ladder, repeating the process. Finally, the only people that really win are those in their final houses or those that bought multiple investments some time ago. It is these people that get to spend the money. Many others feel rich based on their perceived paper wealth. This wealth is sometimes accessed through financial instruments such as Mortgage Equity Withdrawal, which is basically more money imported from the future sale of a house and spent today. Others just like to think their paper wealth is real. This, in economic circles, is called asset illusion (until you sell it, it isn’t actually worth anything). This relatively complex concept of importing money from the future actually illustrates a crucial component of the modern economy. As earnings have failed to rise fast enough we have financed our current economy and its recent growth by importing consumption from the future to provide a lifestyle for some today. You should be able to see how this cannot continue indefinitely. It requires ever more credit, at ever easier or longer terms, and ever more willingness to take on potentially crippling debt in an increasingly volatile world. In short, it’s a problem.
To summarise, a person buying today will have to invest many times more labour, many times more actual clocked-on work effort, to pay for the roof over their head than any other buyer at any other time. It is not more affordable, and the apparent initial cashflow can tease borrowers into debts that will affect their future financial wellbeing and consumption potential in the future, along with the sustainability of the economy.
Is There a Better Way?
In the early, darkest days of the recent credit crunch a long term solution to this problem was actually suggested. Indeed, perhaps surprisingly, the solution has been previously tried and tested. It is simple: if mortgage lenders were to return to traditional levels of earnings multiples, perhaps 3.5x or even 4x salaries for a new mortgage, then borrowers would not be saddled with excessive long term debts. This is what in fact happened in the 1950s in the UK, when interest rate and inflation conditions were actually quite similar to today but bank lending practices were more “restrictive” and there was no damaging credit-based housing bubble.
In this 3.5-4x earnings mortgage system the total loan payments of new debtors would stay similar to previous generations as a percentage of lifetime earnings. Careful management of the lower payments in the early years/higher payments in the later years issue would even enable these new debtors to trade up more regularly, keeping the traditional housing ladder. This would be most easily facilitated by encouraging new mortgage holders to save or invest the early “excess” instead of spending it, ensuring that it is available to offset the later, higher payments later. A first step in this solution would be for the government to educate the population about this issue, and the nature of long term debt payments, and as part of this effort require that banks provide dedicated savings solutions that help debtors save, perhaps even with tax incentives. An alternate step is to design mortgages such that if the nominal interest rates are low then the term of the mortgage contracts, meaning the debt is paid off more swiftly and the “ladder” remains intact.
Of course, this will never happen. The incentives that currently exist in the market place make this extremely unlikely. For starters, it would hit the bottom line of banks today – they make profit based on the size of their customer’s debts (the more the better) and they are incentivized on a short, yearly schedule for staff bonuses. It’s not just the banks though – a 3.5x multiple would ensure that the current decline in house prices would continue until they hit more sustainable levels. This would hit people’s perceived wealth in the short term. Most property owners in the current marketplace suffer from Asset Illusion, in that they perceive they are richer than they necessarily are based upon their perception of their paper worth. They feel rich. Even though for most (i.e. anyone planning on moving up the ladder) price falls will make them better off, the perceived pain of deflating house prices will dissuade them from this solution. Furthermore, it will directly hit the bottom line of estate agents, surveyors, and buy-to-let investors. All of these groups will join a chorus of disapproval in the popular press and are more than capable of swaying public opinion, which of course will put pressure onto elected officials, or more importantly, those that want to be elected or re-elected. The calls to address the issue would be loud. Unfortunately, for many participants in the market place the sustainable path is not the path that makes them any money or provides any power. The burden of future payments is almost exclusively on the young, who vote little and are generally unaware.