that Interest Only Mortgage timebomb again – FCA edition

How did you go bankrupt? Slowly at first, then all of a sudden.

I once heard a father tell his son “There are a lot of stupid people in this world”. And if the FCA really is right that many people don’t realise that an interest only mortgage doesn’t buy the house, then they fall into this class. It’s in the name – interest-only. As opposed to repayment mortgage. Y’know, the one where you repay the amount you borrowed. Duh…

Here we have Robert, a fellow 18 years away from the end of his interest only mortgage. He is surprisingly savvy about his plight, having been aware that in the past you would only be allowed to get out of the door with an interest-only mortgage if you had a parallel savings product for the capital. Often an endowment, but a S&S ISA is a good match too. If you save £10k a year in cash, after 25 years you would have enough to buy the average non-London UK family home. 25 years is long enough for the stock market to give you a decent stab at getting ahead

Framing, dear boy, framing.

Listening to Robert, one of the things that struck me was that for some people, an interest-only mortgage could actually be a very good idea, even if they know they will never pay back the capital. In Britain, a lot of renting is on assured shorthold tenancies, where you can be kicked out of the place every six months, even if you comply with all the conditions of the tenancy. A lot of people want to have children, and for that they need to have a house bigger than the one they will need as empty nesters. A 25 year interest only mortgage is a good match for that situation – it’s long enough to raise a couple of children to maturity, and when the time comes at the end, hell, sell up before the time is due, pocket the nominal profit that 25 years of inflation will give you plus anything house price inflation gives you, then rent or buy your empty nest.

The pros are

  1. as long as you pay your mortgage, nobody gets to kick you out of your house.
  2. You can paint the walls, do DIY,
  3. there won’t be a succession of landlords trying to run off with your deposit, move you on etc.

You will never own the home and never plan to – because it’s too much house for the one you will eventually own or rent. As a way to use other people’s money to pay for the extra space you need to raise children, it’s a good deal, as long as you can dodge the cons. You are renting from the bank, but as long as you know that, it’s fine.

The cons are the three big ifs.

  1. You need to make sure you always have enough coming in to pay the mortgage, up until the time you sell.
  2. You need to make sure you have a job for life so you won’t have to move to chase work, or live somewhere like London or pehaps Cambridge where there is lots of work around so you can find alternative work without moving
  3. You need to stay together with the person who brought the children into the world with, and quite frankly from observation I would not say having children always improves the stability of people’s relationships, but hell, what do I know 😉

The modern world has become a lot more inimical to the chances of success at dodging the cons, and you have to dodge all of them for 18-20 years to make a go of this. I wouldn’t bet on it, if I were starting out now.

One of the toxic legacies Thatcher left us was the notion that owner-occupation was the only proper way to inhabit a house in Britain. It runs deeply through the British psyche, and leads us to overpay for housing. Other countries rent happily, even as families. Generation rent may want step back a little, and reframe its thinking

  • You can now work and study in other parts of the EU. You may be able to save yourself a shedload of cash at the further education and the home ownership stage for the cost of learning a foreign language.
  • The EU is not your only choice, though you may have to jump through more hoops.

Back to Robert. He is being a complainypants and has surrendered agency. He has 18 years to go. Inflation kills your money, roughly halving its real value every decade. 188k sounds like a lot of money now, but it will have a value of only about 47k in today’s money by the time his mortgage falls due. Now I appreciate that’s still a lot for a gent with £6.86 of savings, but in practice it means he needs to save in real terms about £2600 a year in today’s money, about £200 a month.

That is tractable with frugality. He needs to buy less consumer shit, stop going on foreign holidays, and tighten his belt. In particular, if he starts to pay that off, it will reduce the amount of interest he needs to pay, resulting in a virtuous cycle. The tragedy with a mortgage is that it always looks darkest just before the dawn. I never believed I would be able to pay mine off when I started getting the letters saying my endowment was going to fall short. But unlike Robert, I sucked my gut in and started to hit the bugger by overpaying it. And it got easier. It got a damn sight easier when I won a mis-selling complaint and lobbed the entire amount into the mortgage.

In Hemingway’s The Sun also Rises, one of the key characters, Mike Campbell, is asked,

How did you go bankrupt?

His response is

Gradually … then suddenly.

Now normally I am of the opinion that Tom Peters is full of shit, the sort of thing that he has advocated for business is one of the reasons I couldn’s stand working any longer for stupid pricks bean counters that knew the price of everything and the value of nothing. However, he is a genius, simply one misusing his talents in the service of the forces of darkness IMO. One of his acolytes posted thusly

This is so very applicable to a recession scenario. Actually, it is applicable to all our lives—you don’t fail suddenly; you fail gradually through a series of small failures everyday. The day you fail is just a culmination of all the small failures you have had.

There is a little known corollary of this observation. It can be reversed too. Let me postulate Ermine’s Law

How did you succeed?

Gradually and imperceptibly at first, then all of a sudden.

Take it from an old git, because unfortunately you don’t tend to have this experience with finance before late in your forties unless you are exceptionally skilful. It’s why the halfway point of any long term goal is such a dreary and dismal hopeless place. The foundations are of success laid gradually, but the success happens all at once. Look at this graph of how a repayment mortgage repays the capital. You’ve put all the work in steadily, but you’ve only bought a third of your house at the halfway point.

how a traditional mortgage builds equity
how a traditional mortgage builds equity

which I cited in this post. Look how the capital rushes up towards the end.In practice remember that inflation is halving the real value of the cost of your mortgage every 10 years. so not only is the experience really horrible at the start where money is short, but towards the end you can pump up your contributions. That means the all of a sudden effect is even more marked if you have an interest only mortgage like I did and start making capital repayments as you get later into your working life, when the mortgage becomes a smaller proportion of your disposable income – see my case below. That’s the tragedy with saving steadily – you see bugger all for years and it’s hardest in the beginning, then suddenly it all happens – when you don’t need it because you have more money coming in. That’s why the greybeards have all the money in the world – because they’ve been saving a little bit for all their working lives. Death was invented by economists to save the human race from living in servitude to our Stone Age ancestors, some of whom would have been saving for thousands of years and would own everything 😉 That’s why every young generation feels it unfair that all the old gits have the money. I felt that way too in ’84… You’ll get there – if you don’t spend it all and if you don’t inflate your lifestyle with your income like all the admen on the telly say you should.

As another example, take a look at my mortgage and income history, in relative units. Look at that shocking income multiple of 5:1 at the outset – and I was a bachelor at the time, so it was just my income paying this, and I got to see interest rates of 14% p.a.! Buying a house at that time was such a stupid thing to do – it’s even worse than the price to earnings multiples now prevailing, and interest rates are lower now. Again, look at the trajectory – slowly at first, then all of a sudden.

an ermine's inflation-adjusted income and mortgage stupidity
an ermine’s inflation-adjusted income and mortgage stupidity

Robert needs to get a grip. First ask himself it it makes sense to own his house in a couple of decades. If it does, then make the adjustments to his lifestyle to fix that. I see he has a very nice flatscreen TV and nice new leather sofas. I don’t have these. But I own my house. You pays your money and you takes yer choice. Robert needs to do less consumerism and more saving if he wants to own his house. He’s got 18 years to go. He has the choice – adjust his financial flight path and land safely. Or have a fast ride, lots of holidays, cars, TVs and leather sofas, then crash and burn. Interest only is not a timebomb in his case unless he makes it one. The FCA is quite right to be educating interest only mortgage holders that they are on , duh, an interest only product. However, the “I want it all now” mentality and general complainypants attitude means they’ll be wasting their breath. If you take out an interest only mortgage and are surprised that you won’t own the house at the end of the term then you shouldn’t be licensed to drive a £10 note down to the pub, never mind sign on the dotted line of any financial contract.