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.





Why the Demise of the Interest-Only Mortgage isn’t a bad thing

So you walk into a shop, and spot that nice new flat-screen TV you want. £500 to you, sir, or you can buy it interest-only for £2 a month. Wouldn’t you smell a rat somewhere? The rat is, of course, the small print that says you’ll have to pay £500 at the end of the interest-only loan.

Now I know that some people, particularly in the United States, buy their cars like this. It is called leasing, and the name gives it away, you never get to own the car. It’s a long term rent. It looks absolutely and stupendously daft to me, but if the image of driving a nearly new car is that important to you, well, ‘you pays your money and you takes your choice‘.

So what the heck makes buying a house on an interest-only mortgage any different? You still never get to own the house. What it the point of that? The interest only mortgage was a clever wheeze to ramp up house prices and for banks to make more money. The beautiful part of this game is that the buyers go all gooey-eyed and think the mortgage company is doing them a favour by lending them more than they can afford. Hey, that Mr Interest Only Bank can lend me £200,000 whereas Mean Old Prudent Bank will only lend me £150,000. Isn’t Mr Interest Only Bank such a nice guy?

Two words. Northern Rock. It didn’t work out well, even for the lenders.

A history lesson

1960 – the Repayment mortgage

When my Dad borrowed his first £500 mortgage, way back in the early 1960s, it was simple. He told them his income, they looked up in a table what they could lend him, and armed with that knowledge he could look for a house. He borrowed the £500, and then paid them the interest plus a proportion of the price of the house, the latter proportion increasing with time.

Repayment mortgages were all that were available, based on the simple premise that you pay your instalments for 25 years and when the last one is paid the house is yours.

1990 – the Endowment Mortgage

Fast forward thirty years, and I get to go to the Abbey National, and bamboozled by the choice of endowment and repayment I foolishly go for an endowment mortgage. This is still on the principle that I pay interest only to the mortgage company, but simultaneously to a life-insurance policy which supposedly grows with time till after 25 years it is worth at least the price of the house. So although I was only servicing the interest on the mortgage, I was in parallel accumulating an asset that matched the cash price of the house, which when paid to the mortgage firm would discharge the debt. And the house would be mine. The mortgage company took a charge over the endowment, so I couldn’t sneakily stop paying it without them knowing.

2005 – The Interest Only Mortgage (Don’t Bother with the Capital, it’ll work out somehow)

Like an endowment, but endowments got a bad name, for not paying enough to match the price of the house. So just do away with the need for an endowment! How does that work? Well, you get to the end of your 25 year term, and you still owe for the house! Okay, so inflation hasd probably halved the real value of the debt, which is all to the good, but you still don’t owe your damn house at the end. It is a leasing arrangement. Why not just rent instead?

The assumption is that rampant house price inflation means that your house is worth so much at the end that the increase covers the total. But you still can’t sell off the chimney or your third bedroom to discharge the debt, and you are likely to be coming up for retirement. I wouldn’t want to have to stick my hand in my back pocket to come up with what I paid for my house over a decade years ago, though as it is I could just about do it.

increasing complexity, decreasing security and honesty

There’s a lot of bleating about interest only mortgages, because about a third of firt-time buyers bought their houses on an interest only basis.

Shockingly, I heard a father talking on Money Box about how it was so rotten that his son couldn’t find an interest only mortgage to buy his first house. David from Sussex said (13:45 on the iPlayer)

a bit surprised and disappointed to hear they’re only looking to offer capital repayment mortgages, and with my son’s circumstances, which I’m sure is the same for a lot of other first time buyers, the intention is not to stay in the property for that long

So how does that work, then, David? Are you saying your son doesn’t need the house after a while, can sell up, pay back the capital from the proceeds and stick a tent on the pavement? Or do you want him to be able to overpay for this house, so he doesnt’ spend the excess on booze and fast cars? Why exactly is it that you want him to borrow more money for a house he can’t afford the buy, only to lease? Do you realise, David, that your son is in an auction for houses, and if mortgage companies don’t let people borrow so much money then the auction price will fall?

It’s too late to save the people that did overpay for houses by going interest-only to the max, but we can at least not propagate the mistake. If you are going to buy a house, then buy the damn thing, don’t lease it for 25 years and then wonder why it isn’t yours…

Overall, look at the changing mortgage proposition over the years. My Dad was offered an honest and straightforward service. Pay this much for the next 25 years, and you will own your house.

I was offered a less honest service but at least one that in theory would end up with me owning the house. It didn’t work out that way because the complexity of a with-profits endowment hid untestable assumptions and I was stupid enough to buy a product that didn’t match my circumstances. In all fairness to my parents, they told me a repayment would be better for me, they told me why, and educated me well enough to be able to see why, but I was a damn fool and had eyes only for the potential gain, without the wisdom to look for the potential loss. That’s what being 28 did for me, I knew everything and nothing, so greed trumped wisdom.

Unlike my parents, David is failing his son in giving him only half the story. If he actually told his son, “look, you are taking a very serious risk here by going interest only, but you are in a profession where your pay will increase dramatically and as long as you start saving for the capital from then on you may consider this a calculated risk” then that would make all the difference.His son would still be taking a risk and would probably be just as cocky as I was, but at least David would have discharged his duty as a parent 😉

He sort of alludes to the early years being hard, but wage profiles may be flatter nowadays and young people start out with more debt, so the assumption that money will be easier after five years probably doesn’t hold. David needs either to underwrite his son’s migration from interest-only to capital repayment with the Bank of Mum and Dad, or not encourage his son to overpay. Because it’s simple to summarise the issue

if you can only afford to pay an interest-only mortgage on your house, then you can’t afford to buy that house.

Although I think the demise of the interest-only mortgage has been exaggerated, its death would be no bad thing at all.

No more Interest-Only Mortgages from the Halifax

Every so often you come across an amazing piece of news, something that makes you wonder if people have been asleep at the switch for the last few years. Let’s hear it for the good people at Halifax, who have just woken up and decided that perhaps they would like to have some documentary evidence of people being able to pay back the money they lend to them, as opposed to just being able to pay the interest.

Uh? What part of liar loans did they not get at Halifax? Let’s hear some of the excuses for interest only loans from Melanie Bien, representing some bunch of charlatans delivering empty promises mortgage brokers:

“High-street lenders have been tightening their interest-only criteria since the downturn because they regard these loans as more risky than repayment deals. If this continues, interest-only mortgages could vanish, or become so limited in scope that they are available to only a handful of borrowers.

Interest-only loans aren’t inherently bad. What about first-time buyers who don’t have a repayment vehicle but are due an inheritance? Or someone with a modest income but sizeable and regular bonuses which can comfortably be used to clear the capital?

‘One size fits all’ does not work when it comes to mortgages. For some borrowers, not all, interest only is the right choice.”

Melanie, my dear, I don’t know if you really were born yesterday or you are thinking of your commission, but you are wrong. The tragedy is that if a borrower needs an interest only loan to be able to afford it, then an interest-only loan is inherently bad for that customer. That is because it is allowing them to live beyond their means, and they are also driving up house prices in general with the other people living beyond their means, achieving a drive-by shooting of many people’s personal finances.

There are some people that know how to use interest only mortgages. They are few and far between, and will have uncommon characteristics, like having large share portfolios and accumulated capital wealth. The sort of punter that needs Melanie’s services is not one of them, so when she says “you can afford this house if you start with an interest-only mortgage” she is always wrong.

There’s no money in it for her to say “you can’t afford that much” but the rule is simple. If you have to ask whether you can afford it, and the answer is “yes, if you go interest-only” then simply replace that statement with “Do you feel lucky, punk? Well, do you?”

Buying a house is a big commitment. It’s hard enough to rely on having a job for 25 years. If you are relying on a bonus regularly then you are playing Russian Roulette with your finances. The whole point about a bonus is that it’s a bonus, so it can’t be relied upon…

It’s really staggering that it has taken getting on for three-and-a-half years for the Halifax to realise that interest-only mortgagees aren’t so much high-risk as they are bad risk.

Let’s face it, if you really want an interest-only mortgage, it’s hardly as if the Halifax are really raising the bar that much. Tell them you will pay off the loan with an ISA, and have the presence of mind to be able to produce evidence of having had that ISA. You can always cash it in after you have secured the loan if you really want to rent your house from the mortgage company. The new rule isn’t so much documentary evidence of having a strategy to repay the capital, more documentary evidence of having had savings for a year. If you really can’t drum up the savings then borrow the money from a credit card and put it in an ISA. You would be absolutely dead-certain certifiably mad to do that, but it would probably work.*

*please, please don’t do this. Halifax may check your total credit score and see the card loan, your ISA may fall in value by the time you want to cash it in to repay the loan, there’s just so much that could go wrong. If it still looks like a good idea, back away slowly from your computer, and seek independent financial advice as soon as possible. Oh and you probably can’t afford the house, BTW…

Interest only mortgage – Do you feel lucky, punk? Well, do you?

Monevator has a good post about using an interest-only mortgage as an investment tool. You have to live somewhere, and if you have the discipline then it’s a great way to build up an investment portfolio over the term of the mortgage which will pay off the capital.

Hey, where did I hear that before? Ah yes, as a late-twenties starry-eyed young pup in the market for his first mortgage. Abbey National’s estate agents at the time, Cornerstone, sold me a mortgage. I went in wanting a repayment mortgage, like my Mum and Dad used to have. Lovely LAUTRO saleswoman, Sue she was called, gorgeous green eyes…

“You can do better than that. with an endowment you just pay the interest, but look at this Friends Provident with profits fund. Look at these lovely growth figures. At the end of your 25 years you’ll have twice as much in the endowment as you’ll need to pay off the capital”

Sucker. I was had. These were the years of Gordon Gekko, Greed is Good. Beware pretty saleswomen promising the earth. I was single, so the one benefit of an endowment, the life insurance part, was worthless to me or anyone I cared about. But 100% profit in 25 years, well, that had me. That’s the takeaway message I got, I am sure somewhere in the fine print there was the usual past history is no guarantee yadda yadda. But I was lost to the green eyes and the promise of lots of moolah. I hope it was the moolah that swung it rather than the eyes…

A few years later, the house underwater on the mortgage, Friends Provident demutualised and I got seven grand. Which, having gotten wiser, I paid down to the capital. On the principle that there were now nasty shareholders rather than cuddly mutuals so I would be ripped off and enjoy poorer with profits performance, so I better at least use it to reduce my interest payments.

Then the letters came saying “sorry old chap, but we were a tad overoptimistic in our predictions it seems. You, mate, will be lucky to get half towards your capital, so you better raise the amount you’re putting into our rotten with profits fund to catch up. Ta-ra”. Or words to that effect. I saw red and wrote the MD of Friends Provident a stinking letter telling him their salesperson had promised me a guaranteed return. He, or rather some lowly grunt on his behalf, wrote back after a while saying “no we didn’t, but you can moan to us, then the Ombudsman if you like”

So it was that after moving I ended up with an interest only flexible mortgage from those nice people at Birmingham Midshires. Nobody wanted to sell me a repayment mortgage in those heady days of the dotcom boom.Every year I’d pay off a lump I’d saved to reduce the capital.

Some lengthy time later, Friends Provident settled with me to put me back in the position I would have been had if I’d taken a repayment mortgage, which was sixteen big ones they’d lost me in ten years. I paid this towards the capital of the new house. No foreign holidays, kitchen refits or cars were involved here 🙂 Having screwed up royally in the dotcom boom I learned, do not churn, sit on your hands, and continued to pay down the mortgage. From 2003 I changed tack, and started investing in a dead boring Legal & General tracker fund, using some of the money I’d otherwise be putting into the mortgage capital repayments. That did help me steal a march on the mortgage, and it 2006 I reduced the mortgage to the minimum BM would allow me to have. This was a flexible mortgage, so I could ring them up, and they would transfer to me any amount from 10k up to my overpayment into my bank account by BACS.

People often advocate an offset mortgage, where your savings with an institution are offset against your mortgage, so if you have a mortgage of 100k and savings of 50k you only pay interest on 50k. That sounds great, except in the credit crunch. Because the small print says they can forcibly use your savings to pay down some of the mortgage. So the general rule is never hold your stash of cash with the same organisation or banking group that holds your mortgage. This happened to someone I know, which screwed them royally.

I liked the disconnect of the flexible mortgage. Although I used shares ISAs to save my capital (effectively doing myself what Friends Provident had so miserably failed to do on my behalf) I never tackled this with the intent and savvy that Monevator proposes. But I can vouch that it works, I paid my mortgage down with about 10 years left to run. And paid the mortgage company  less than a tenner a month while I mulled over whether I wanted to discharge it. Monevator would make a good case that I shouldn’t have, I could have invested in 2008 and made a mint, and indeed could have had 11 years more use of this cash, currently at rock-bottom rates. But I don’t have his edge and ambition, and in the end I wanted my house to be truly mine.

2007 mortgage statement. BM didn’t get fat off my back that year 😉