I’ve recently been thinking a lot about mortgages, because I’m getting a new one. At the same time I’ve been educating myself about investment risk tolerance (1,2). I’ve done lots of online questionnaire’s to evaluate mine, which broadly show I’m willing to tolerate a lot of risk; I’m youngish, can wait most storms out and have a background in a profession where I have to manage risk daily. I also have the capacity to tolerate that risk; I make a good, secure salary and I won’t be investing money I can’t afford to lose. That’s not the case for my mortgage though, the single last purchase/ cost I’ll probably ever make. A post last week on r/UKPersonalFinance got me thinking:
Stick or twist?
Are you mad Shrink? You need to fix, fix, fix, before the rates go up. Everyone says they will: the BBC (3,4), Newspapers (5,6,7,8), lots of blogs (9,10).
Is what everyone was saying when I was looking last week. Except the rates didn’t go up. We had crappier than anticipated economic results, and the BoE said no (11). It cut it’s growth forecast and interest rates remained on hold at 0.5%.
Well they can’t stay that way!
No, they probably won’t. But they could do, pollsters and pundits have been off before. They said Lehman Brothers, Northern Rock etc were too big to fail. They said Brexit wouldn’t happen. Predicting the future is Mystic Meg’s domain.
Mark Carney – will the last one out please turn off the lights.
Four years ago MrsFIREShrink and I were looking at putting our hard-earned deposit down. As 20-something millenials we were pretty unusual to be in that position. We leveraged a 90% LTV on a do-er-upper in the area we both loved, worked and intended on staying in. In those pre-Brexit, pre-May/Corbyn, pre-economic flatline days everything pointed to fixing for as long as we could. 4.29% fixed for 5 years was the best we could manage. That was ok as when we bought we planned to renovate and stay there for 5-10 years.
Fast-forward four years and we’ve moved 150 miles for job opportunities we couldn’t pass up but never anticipated. Our old house is for sale, and we’re trying to port our mortgage to save paying our eye-watering (5%!) exit fee. We’ve learnt that long fixed rates have their downsides (12). We look at others fixing for 10 years, who have no plans to move, and think about their flexibility (13,14). Going back to those trackers *affix hindsight glasses* had we selected a three year tracker rather than fixing we would have saved thousands in interest. This time we’ve taken information from a number of different sources, and used online calculators to think about our best financial options (15). Cardinal rule learnt: Always consult multiple sources, references and opinions before purchasing.
Where’s the risk?
Why didn’t we go for a tracker 4 years ago? We wanted to minimise our risk to a rising base rate. Despite being tolerant of risk in work and in cash/ stock investments in the past, I’m not for my housing. I started to think about why, and where the risk lay:
- LTV – How much you’re willing (or the bank is) to leverage your cash against future earnings.
- Monthly repayment figure – How much you’ll be paying back a month, and if you can afford it.
The two are obviously inextricably linked. Our LTV has improved to 80%, which looks to be optimal for interest rate offers. Risks/ costs worth considering:
- Under-leverage – borrow less, with LTV 60-80%, and pay less on interest due to better rates and lower value. Buy a smaller property, but risk missing out on the extra equity caused by a potential increase in house prices.
- Over-leverage – borrow more, with LTV 80-95%, and pay more interest due to higher rates. Buy a larger property, put more money in monthly, so more equity in the long run. Greater exposure if there is a house price falls resulting in more negative equity.
The tolerance for this definitely varies amongst my friends and acquaintances. The common theme amongst blogs I’ve read has been to leverage to your max, 90% at least, as long as you have a good duration (25 years+) of work-life human capital left. This seems to be driven by the view that property remains a good long-term investment option. Monevator does an excellent piece on this, although as it’s 2012 it’s a bit out of date (16). Just look at the long term trends below to get the picture:
Anecdotal evidence; I have a close friend who bought on a 85% LTV five years ago. He bought a property in an up-and-coming commuter belt, and the house value increased by about 25% (good on him). He took this and leveraged at 90% LTV on a thumping great Barratt executive home (le sigh), so in his early-30s is sat in a half-million pound house. He’s willing to tolerate the exposure because it’s their dream home and they intend to stay there 10+ years.
Digging a bit deeper into those trends to understand whether now is a good time to go max-LTV is difficult. The question; Have property prices always been a good investment? Could be a whole separate post in itself, but suffice to say it’s difficult to answer. Most property prior to the post-war housing boom was owned by landlords and rented out (are we heading back that way?). The British obsession with owning your own home is a new one. UK house price index data only reliably starts in the 1950s, but this LSE blog looks at land prices going back to 1892 (which helpfully are no longer published) (17).
To unpick this data note that the value of the home is made up of the value of the structure and the value of the land combined. This blog by James Gleeson summarises dis-aggregating house price value (18). From it I take this graph:
So, we see that the value of the structure increased slightly once inflation-adjusted, but residual values, i.e. that value of the land, is the source of most of the increase. This is also visible in the price of undeveloped land. Review the historic trends from the former LSE graph and we see that the increase in value is a modern phenomenon, and the long-term investment strategy of property is not so long term.
Short-term LTV Outlook
Again, another whole post in itself. In 2016 the UK Value Investor reckoned that UK house price forecasts weren’t looking good (19). Two years on and the market, as discussed in recent Full English Accompaniments, looks to be stodgy. Back then, UK Value Investor reckoned that house prices were in a bubble and due a crash. This was based on price to earning ratio data:
From UK Value Investor (19)
“Here’s a quick description of what that chart shows:
- The black line – The average house price in each year
- The red zone – Where the average house price would have been if houses were historically expensive, i.e. if the PE ratio had been between 5.5 and 6
- The yellow zone – Where the average house price would have been if houses were at historically average valuations, i.e. if the PE ratio was between 3.8 and 4.5
- The green zone – Where the average house price would have been if houses were cheap, i.e. if the PE ratio had been between 3 and 3.3″
The whole article is worth a read if you haven’t before. John predicts:
Expected capital gains from UK housing are zero over the next ten years
Which two years on looks pretty fair. His assumptions hold that house prices won’t crash, but will stay relatively flat while wages catch up. Worth considering if you’re buying now expecting a 10-20% increase in the value of your holding. Why waffle about this – it nullifies one of the arguments for a 95% LTV.
2. Monthly Repayment Figure
Back to our original list and the monthly repayment figure. A function of mortgage duration, principal sum and interest rate. I’m not going to go into duration so much, as this appears to be more a personal choice and dependent on how much human capital you have left. Opting to pay a short duration means more/ month, a long duration = less. People modulate their monthly repayment on big houses with high LTVs by going longer on their duration. The risk here is about what % of your earnings you’re going to be spending on your mortgage. Lenders set their affordability calculators on earnings, up to 4.5x, but this has got stricter. There have been concerns that borrowers who were previously approved will now struggle to remortgage due to the affordability rules (20, 21, 22).
The traditional model argues to aim for 35% of your pretax income to go on your mortgage, 45% at a push (23). Dave Ramsey advocates a conservative 25% of take-home (24). UK-wide this is on a downward trend, with Halifax reporting it’s dipped to around 29% in 2017/18, but with massive regional variability (25, 26). This has a complex interplay with affordability and price-earning ratio.
Bottom line – you don’t want to be paying so much on a mortgage you can’t afford other day to day activities. Money Advice Service and Money Saving Expert have good tools to work this out (15,27). The balance between fixing or tracking affects interest rate. Generally go for a tracker and it’ll be closer to the BoE base rate, go for a fixed rate and you’ll pay some percentage for the choice. Money Saving Expert also includes tools to compare trackers, or calculate if paying out of a fixed rate mortgage could be better value (28). People are fixing to avoid a base rate rise, and there’s various calculators available to help with this too, allowing you to calculate how much extra you would pay (27,29,30). The risk if you don’t fix – the BoE base rate skyrockets and repayments become un-affordable.
Anecdotal evidence; I have a colleague who’s a bit of a flash git. At 28-29, he owns 3 properties (from a standing start) and drives a new LR Discovery (on PCP/ lease). He achieved this by buying a small property straight out of university, sub-letting rooms, using the cash created for a second BTL property, and then leveraging that for a flat. All on about 80% LTVs. He works full time 48 hours a week in the medical profession, then does another 20 hours on top overtime to pay his mortgages. Just thinking about it gives me the collywobbles.
What have I learnt?
My risk tolerance for my mortgage is substantially lower than for investments. Our LTV is now 80%, we’ve opted for a shorter (2 year) fixed rate on our extension while our other fixed rate runs out, and combined these make up 39% of our take-home income. Once burnt, twice shy. We’re hoping to fix next year on the other larger principal, and that rates remain low. This seems likely looking at conditioning paths (31). Even if it rises to the long run UK average of 5-6% we’re comfortable. In face we’ve calculated that we can tolerate up to a 10% BoE base rate and still be ok. Those would be days of property price collapse, repossessions, defaulting and as Ermine over at Simply Living in Somerset teaches us the hooded figure of negative equity (32,33). We’re not at the 15% of the the mid-’80s, and it seems unlikely we will be any time soon, but my tolerance for the chance of losing my home is minimal (34,35). But if you have the stomach and the wallet for it, then maybe a tracker is a decent current option. Ultimately I’ve learnt I’m not willing to gamble my home or my family, and I’m not so gung ho after all.
The Fire Shrink