Everyone knows that a mortgage rate at 3%, or less, is cheap, justifying higher house prices and a strong consumer economy.
It’s such common sense that everyone from the man on the street to the highest central banker “knows” this is the case. Shame everyone’s wrong then isn’t it? Not only that but wrong to the extent that it could easily cost more than 20% of you or your clients wages eventually.
If this statement makes you think “wrong, wrong, wrong”, tut and shake your head, think it is simple headline grabbing stuff then sorry; but you are wide of the mark. But don’t be offended you are in the good company of, well, almost everyone.
Unfortunately this basic misunderstanding of debt dynamics lies at the heart of why the world is now so irretrievably over-indebted, why a further crisis is both inevitable and, unfortunately, it appears necessary to change the deeply destructive dynamics of a world that has forgotten some very basic financial maths.
However to get to the heart of the matter you have to ask the key question that should lie at every stage of every financial decision (but usually sinks below a sea of assumption) and that is: WHY?
Most importantly: WHY ARE INTEREST RATES SO LOW THAT I CAN GET A 3% MORTGAGE? The answer is because inflation is so low, indeed just this morning (Friday 20th November) we have a key German inflation figure (PPI) showing -2.3% over the year. As a result we have base rates on the floor (ZIRP or Zero Interest Rate Policy) and now that banks have (to one degree or another) patched up their balance sheets, this has resulted in mortgage rates where they are and this is the key. (Note: Although initial mortgage rates may be below 3% most APR’s appear to be 3%+ hence the choice).
You see a mortgage is usually a 25 year commitment and should be costed accordingly and this is where the problem begins in that for the affordability to remain in place you have to make assumptions over that type of time-frame, as a business does with all long term debt commitments. So lets look at how that works (Note: We can complicate this discussion with many variables – most of which make the situation worse – however that is missing the key point which mathematically remains pretty constant regardless)
Now if you assume the 3% remains constant, so not providing you with any unexpected mortgage hikes we assume bank base rates stay on the floor, which is only credible if inflation stays on the floor, which also assumes subdued gross economic growth and hence inevitably subdued wage inflation.
So let’s look at an individual who earns £2000 per month after tax. Their mortgage is £1000 per month and hence takes up half their take-home pay. No lets assume other things (such as tax rates, promotions etc) remain equal and assume 1.5% wage growth, while the mortgage remains unchanged (assume repayment mortgages in each case, so this mortgage will have a higher capital to income ratio than under a higher rate environment, which has been the case over time…..hence housing multiples to income expand because it’s “cheaper” to buy houses….depending which housing market valuer you take UK houses are currently between 6.75 times to 10.4 times the median wage).
After 1 year the mortgage falls to 49.3% of net wages, after 10 years 45.7%, 20 years 37.7% and at 25 years it is 35% of take home.
Now let’s compare to an earlier time, flares are in fashion, the Bay City Rollers are bizarrely popular and inflation and interest rates are higher. This changes the basic figures but lets keep the mortgage payments constant, assuming a repayment mortgage against a lower sum but with higher but stable interest. Now most of us will know older family and friends who will telly you don’t know you’re born and how their initial mortgage rate was 16%, which is from a time when inflation was in double digits for years. But was this more expensive? Errrr…… No as the simplified example below shows (and we are ignoring complications such as the lower wage/house price multiples of the time and things like Mortgage Interest Relief At Source – MIRAS- which provided income tax relief against mortgage interest, which when it’s in double figures is significant).
Let’s assume the mortgage is again £1000 per month, but lets take a lower wage of £1600 per month to mimic our parents initial hardship, and then let’s inflate those wages by 10% annually under an inflationary scenario.
Initially the mortgage is 62.5% of net wages. After 1 year it falls to 56.8%, after 10 years 26.5%, 20 years 10.2% and at year 25 6.3%….or 29% less of your wage than above.
Now lets get really curmudgeonly (Think Monty Python’s Yorkshiremen sketch “When I were lad got paid a shilling a month, ad million pound mortgage, begged for me cloths and were ‘appy to eat gravel”) and assume a £1000 mortgage and a £1000 wage under the same conditions.
After year 1 the mortgage is 90.9%, after 10 it’s 42.4%, after 20 years it’s 16.4% and after 25 it’s 10.2%…..25% less than our first example…..the power of compounding works both ways.
Mortgages are cheaper when inflation is high, even if the initial cost means you can’t gear up as much (which is amusingly why higher interest rates curtail asset bubbles……lower rates encourage asset bubbles……..Federal Reserve, BoE, ECB,….. Beuller…Beuller…..Anyone?)
The simple mathematical fact is that inflation erodes debt, deflation increases it. Central Banks can’t generate the former and we are on the cusp of the latter.
But this isn’t news. When I first did Accountancy training 25 years ago I was taught straight away that debt is attractive in a high inflation environment as it reduces dramatically with time. This basic fact is why central bankers are now concerned about resurrecting their old enemy as we wallow in debt. When I then did investment training (I have been investing directly in Government and Corporate Debt for around 20 years) I was taught that debt (bonds such as UK Gilts) when issued at low interest rates and with long dates to maturity (so like a mortgage now) suffered much higher interest rate sensitivity/value-at-risk than high interest bearing bonds, particularly if they had less time to maturity.
Put simply long term interest rates are tricky things, and speaking as an investor who has taken successful positions in long dated government bonds, deliberately against the predictions of Central Banks (and most of the market) about their own interest rates, I appreciate more than most how complex the variables around this point are and how much the above is simplified (although if we try to make the above more like real life it just gets worse…like the idea of cashing out your equity for the younger generation to buy with even greater debt loads). However the simple truth is we have pushed interest rates and inflation to the zero bound, which is manageable if debt loads are low, but not when they are so high. Indeed so perverse is the world now that watching CNBC this morning you could first see worries about deflation in Europe and then discussion about taking on more debt to stimulate economies to generate inflation…so building up our liabilities further pushing a policy that refuses to produce inflation, only higher levels of debt. This is literally on the edge of insanity.
Indeed over the last few years almost all of the “Global Recovery”, what little there is, has been bought at the expense of more, not less, debt than GDP produced, and helped foster deflationary conditions that make this debt load ever more of an albatross around our necks.
In short 3% mortgage rates don’t make mortgages cheap, anything but, and they remain symptomatic of a broken world economy. This is not simply opinion it’s a mathematical fact and while in the 2000’s many buried their heads in the sand (and many got away with it being rescued by ZIRP and QE at the expense of the prudent savers) most people now appear to be fully buried in sand, unable to see the obvious, at least until the financial tsunami comes and washes it all away.
Please be aware when taking on your own commitments and be very, very aware if you find yourselves advising others.