Mortgage Models

Buying a home is a goal of many people in the UK given the general belief that the cost of renting a property can almost appear to be the same as buying. Equally, there is the perception that investing in property is a safe bet, as house prices appear to rise faster than inflation, so that a property owner eventually benefits in terms of increased equity, at least, in principle. As such, the following graph of average house prices in the UK would appear to support this assumption.

Before jumping into the financial pros & cons of buying a house using a mortgage, the assumption that it is a no-lose investment should be examined for the following reasons:

  1. The past does not always reflect the future and there is no guarantee that a similar graph drawn in 30 years time will mirror the one above. 

  2. Prices do go down, as reflected by the`% Change` below the dotted line. Therefore, people can get caught in a situation where their mortgage exceeds the market value of their property, referred to as ‘negative equity`

  3. The final issue is slightly more detailed and speculative, as house prices in the UK are partly driven by supply and demand. When demand exceeds supply, the prices rise, which has been the situation for a number of years in some areas, like London. However, high earnings, foreign investment and easy access to credit have all helped to inflate house prices well beyond normal wage inflation. This situation may not be sustainable.

As indicated, where relatively low numbers of new houses are being built, and possibly attributed to the availability of land, demand can exceed supply. So let us consider the implications of the cost of land, because it could have a long-term effect on house prices. Today, a hectare (100 metre2) of farmland costs in the order of £8,000, but the same land with building permission could cost as much as £1,000,000 in the right location. This is an increase in value by a factor 125, which has caused many to speculate in farmland that might eventually acquire building permission, but that is another story. The number of dwellings that can be built on one hectare depends on the type of dwelling in question and the scope of the planning permission. For example, in the context of urban high-rise flats, the density per hectare may be over 100, while a more typical housing density might range from 10-20. If we use this latter figure as the basis of our example, the cost of the land could range from £50,000-£100,000 per house. Therefore, we might  breakdown the cost of a basic house in the UK as follows:

Component Cost
Land £50,000
Materials £50,000
Labour £50,000
Profit £50,000
Total £200,000

It is probably reasonable to assume that materials and labour will stay in-line with inflation, although self-builds can dramatically reduce labour cost and negate third-party profit, while land prices may be subject to political change. For example, there is increasing pressure to release farmland for development and reduce planning bureaucracy to meet the growing demand for housing. While this approach would be resisted by the ‘green’ lobby’, there is an environmental argument suggesting that monoculture farmland can be equally harmful to the surrounding environment and changing this land to houses with gardens might be ecologically beneficial. As such, any future reduction in land prices could see a fall in house prices, if supply started to match demand or enough political change takes place to help first-time buyers. Of course, this is just speculation, but such is the nature of most investments, so with this thought tabled, we shall now turn our attention to the current cost of buying a property via a mortgage. As you might expect, the cost depends on how much you borrow and this is normally governed by how much you earn. In days gone-by, there were strict guidelines as to how much you could borrow against your earnings, typically the figure was 3 times salary. Today, there are stories of people borrowing as much as 6-8 times their salary to get onto the property ladder. Given that this level of borrowing would appear unsustainable, we will limit our model to a borrowing factor of 4 on the joint gross income of £53,000, as assumed by the model, which would correspond to a maximum mortgage of £212,000. However, we will assume an actual mortgage of £200,000, where any deposit saved is used to cover all other costs associated with buying a house. This said, the actual cost of the mortgage is very dependent on the interest rates over the entire period of the mortgage, e.g. 25-35 years. In this context, the following graph of historical mortgage interest rates might suggest that the current rates, in the range of 3-5%, might be an overly optimistic assumption for the future.

Based on the fluctuations in the chart above, the follow table shows the cost of a £200,000 mortgage based on a possibly more typical interest rate of 5%, while also showing the cost implications of a return to much higher rates, e.g. 15%, over 25 and 35 years:

Mortgage £200,000 £200,000 £200,000 £200,000 £200,000
Years 25 25 35 25 35
Interest 3.00% 5.00% 5.00% 15.00% 15.00%
Monthly Cost £948 £1,169 £1,009 £2,562 £2,514
Yearly Cost £11,381 £14,030 £12,113 £30,740 £30,164
Total Paid £284,527 £350,754 £423,938 £768,498 £1,055,723
Total Interest £84,527 £150,754 £223,938 £568,498 £855,723

Note: The first column showing the mortgage cost at 3% was used in the initial model. While such a low rate may still be possible in some start-up mortgage options, it is not representative of the direction in which interest rates are likely to go in the future.

The following table now superimposes the figures above onto the financial model previously outlined, where only the mortgage cost is changed. While the initial income model can just afford a mortgage interest rate of 5%, any rise above 7.5% would be unsustainable.

Item 3%
25 years
25 years
35 years
25 years
35 years
Gross Income £53,000 £53,000 £53,000 £53,000 £53,000
Tax £6,600 £6,600 £6,600 £6,600 £6,600
NI £4,451 £4,451 £4,451 £4,451 £4,451
Net Income £41,949 £41,949 £41,949 £41,949 £41,949
Pension £2,120 £2,120 £2,120 £2,120 £2,120
Mortgage £11,381 £14,030 £12,113 £30,740 £30,164
Disposable Income £28,448 £25,799 £27,717 £9,090 £9,666
Household Costs £23,005 £23,005 £23,005 £23,005 £23,005
Balance £5,443 £2,794 £4,712 -£13,915 -£13,339

Is there any ‘moral’ to this story?

While it may be possible to get a mortgage, which is some larger multiple of income, careful consideration is needed in order to allow for some sensible margin for changes in future interest rates. Again, it is worth remembering that the loan company is subject to virtual no risk in lending more than you can afford, as they will simply repossess your home and sell it to recoup your debt, if you cannot keep up payments.

 So, what if any, sensible safety margin is advised?

While many have little initial interest in the idea of ‘financial planning’, there comes a point in our lives when the implications of a poor or ill-advised financial decision can have long-term consequences. Based on the financial models being discussed, the joint income is adequate to cover all costs, inclusive of a £200,000 mortgage rising to 7.5%. Currently, mortgage rates are at an historic low, between 3-5%, following the 2008 financial crisis, which subsequently caused bank interest rates to fall towards zero. As such, it would seem that future interest rates can only rise, although economic mechanisms now adopted by most countries will probably try to prevent a return to the very high interest rates of the 1980’s. This said, the future of the global economy may yet be negatively affected by events, such as global warming and resource shortages in the face of growing populations – see ‘Growing Storm’ for more details. Of course, most people cannot realistically take into account such possibilities and therefore often take decisions based on their immediate circumstances and relatively short-term prospects. As such, we will assume that the partnership in the model may well proceed with the financial commitment of a longer term 35 year mortgage, at an initial rate of 5%, which will leave a yearly balance of £4,712 that is effectively their safety margin.