View From The Mountain

*Modern Housing Myths* There is a lot of assumed “common sense” knowledge regarding the housing market floating around in the press today. This article tries to capture some of these issues and assess whether these assumptions are true or misleading… The first three myths: 1) Houses have always been expensive – they’re not more expensive today 2) Interest rates are lower, so prices should go up - buying an house is just as easy as previous years 3) It has always been tough to buy your first property, but you have to start small – you pay off some of the mortgage and then you trade up - it’s no different today.

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Myth 1: Houses have always been expensive – they’re not more expensive today Are house prices more expensive today, or have they always been expensive? There are a number of ways of measuring the cost of houses. The most obvious measure is the actual sticker price, or nominal price, but for a comparison with previous years it is important to correct for inflation, creating the “real” price measure. Finally, it can be instructive to compare house prices to earnings or rents, highlighting changes through time.

Nominal Prices The Nationwide House Price Survey (link) is the longest running survey of house prices in the UK. Since 1952 this survey has recorded the price of the average home bought with a mortgage financed by the Nationwide building society. As you can see, the price of a house today is much more than 57 years ago.

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“Real” Prices However, the graph above only captures part of the story. It illustrates the nominal price. The nominal price is the actual price paid, but it does not account for inflation. In general terms inflation is the gradual decrease in the spending power of the money in your pocket over time. We all know that a pound or dollar today buys a lot less bread, milk, and goods than it did in 1974. This is because we earn a lot more than we did then, and all that extra money is chasing a similar amount of available goods. As a result everything has gone up in price. Because of this effect a graph of nominal house prices only tells a small part of the story. To fully compare how it feels to buy something at different times it is important to adjust for inflation. Inflation adjusted prices are called real prices. In real terms a #100 purchase in 1974 would have felt approximately equivalent to a #665 purchase in 2009. It was 6 better to be a millionaire in the 1970s than it is to be a millionaire in 2009.

The second graph illustrates that even in real, inflation adjusted terms UK house prices are still much more expensive than ever before (with the exception of the very peak of the “boom” in 2007). The “mountain” at the right hand side of the graph, from about 2001, shows that house prices increased much faster than inflation during this period. This means that even if you had a lot of savings and bought a house for cash today it

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would still feel a lot more expensive than buying a similar house during the early 21st Century or at any time in the 20th Century, including the very top of the 1989/1990 “boom”. You’d simply need more money today, even adjusting for inflation, than you would have needed in the past. It is also worth observing that the real price graph above also shows that the increase in real prices over time is not a given. It can work the other way too. If you go back approximately 15 years to the mid 1990s the real price graph shows that buying a house then would have felt a lot cheaper than buying in 1989, even though in nominal (actual) terms the house would have cost almost the same. This is because a period of high inflation during the early 1990s ensured that wage packets grew quite rapidly each year. By 1995 this meant that a house priced at the same nominal amount as the 1989 peak felt a lot cheaper, and as a result people were able to pay approximately the same amount for a home as at the peak of the bubble without experiencing anywhere near as much financial stress. In essence, wage inflation had made the houses seem cheaper without drops in actual prices being necessary. This meant that negative equity was less of an issue than it might have been in a low inflation environment like today. In a low inflation environment any property price correction will affect both real and nominal prices, as there is no inflation obscuring the real affect. Unfortunately how inflation impacts how it feels to buy a house or, more crucially, pay a mortgage, is commonly misunderstood and ignored. But it is very important - it affects everything from how it feels to pay off a long term loan, the impact of high debt loads, the return on investments, and the level of employment and corporate profitability. Price vs. Earnings How it feels to buy a house is further illustrated by the price vs. earnings ratio. This time the graph corrects not just for general inflation in the economy, but for earnings growth. Over the long term our pay-packets have tended to grow faster than inflation (generally at ~ 2% above). This is generally considered the result of greater efficiency in the workplace, for instance, the impact of computers and the IT revolution during the 1980s and 1990s. Correcting for increased earnings over time rather than using inflation as a proxy creates the Price vs. Earnings graph. This graph represents one of the key housing measures. As you can see, it is similar to the real house price graph in that there is a lot more

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variation than seen on the nominal price graph. House prices have risen and fallen vs. earnings quite regularly. Historically, house prices in the UK have consistently been within the 3-4x earnings range, with notable spikes associated with housing boom-busts of the 1970s and late 1980s. At its peak, in 2007, the house price-earnings graph, at 7x earnings, was some 20% above the previous peak rates. Even today, after a significant fall in house prices, buying a house is more expensive today than any previous peak.

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Crucially, it is the relationship between house prices and earnings that has the biggest psychological effect. As house prices become more expensive relative to wages the housing market begins to feel like a free money making machine. Existing owners feel ever wealthier with little or no extra effort, and in some cases the annual increase in the market price of their home may even outstrip their annual wage. Whilst this wealth is, to an extent, illusory and can only truly be accessed by selling the property and trading down to a smaller home, many owners are able to convert some of their paper wealth to real money through Mortgage Equity Withdrawal, effectively taking out another mortgage on the property. This money can then be either used for consumption or investment. Multiple property owners benefit more directly as they are able to sell their asset and realise their cash without having to find somewhere smaller to live. Finally, even owners who do not directly access their paper wealth are able to feel a lot richer and more

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secure. In aggregate, existing owners feel empowered to spend more, with a decreased appetite for saving for a rainy day or committing earnings to a pension plan. For existing owners this seems like boom time. Of course, whilst many existing owners feel that they have earned their wealth, the winners in this sort of market are defined almost exclusively by timing. Those who due to their date of birth were able to buy before the boom benefit the most. Others able to buy in the early part of the “boom” are also able to benefit, albeit to a lesser degree. It is important to note that these winners feel rich not just because house prices have a large price tag, but that they are expensive relative to earnings. It is by this crucial measure that owners judge their wealth. The apparent ease by which wealth is generated through housing rather than through working ensures that the houseingmarket becomes ever more attractive to new entrants. However, the very thing that makes existing owners feel rich and attracts new entrants to the market - the high price compared to earnings – is the very thing that makes it difficult to enter the market, and even more difficult to profit from it. House prices cannot forever rise faster than earnings without significant social and economic implications. For those purchasing new homes, on which existing owners fundamentally depend to support or increase their paper wealth, the disconnect between house prices and earnings represents a considerable challenge. As the importance of what you earn is diminished the importance of credit or access to a large deposit increases. Of course, earnings still matter, but on a relative scale they are dwarfed in this sort of market by the requirement of access to a large well of “cheap” credit, on ever better or ever longer terms, or increasingly large deposits.

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In this manner, high house prices relative to the amount that new buyers can earn increases the importance of inheritance. The crucial point is that in most cases the wealth of the inherited estate is based primarily upon the price of the family home that was bought before prices escaped earnings. Because of this crucial housing link it doesn’t matter too much to the family if house prices continue to rise way beyond earnings. The larger the price rise, the larger the inheritance. The lucky timing of the early, older buyers can be passed on, in part, to younger buyers, and in this way many families remain relatively relaxed about price rises, considering themselves insulated from the vagaries of the market. This may seem a relatively subtle point but it has important social implications. Families that are property rich today realise that in a world in which house prices are not connected to earnings it is important to pass on as much of their accumulated wealth as possible. They realise that replicating their success is harder, if not impossible (even if they don’t realize how much of that “success” was down to timing) and they rationally want to help their family as much as they can. The continued focus on inheritance tax, including the Daily Mail’s “ban the tax” campaign in the UK illustrates this awareness, and it is likely to become an important political issue with time. But this is unfortunately not the whole story. The issue doesn’t simply stop with wealth planning and tax issues. Families in this position are also aware, at some level, that this sort of housing economy would also represent serious social change. This is most clearly illustrated by the contemporary fear of “missing the boat” and the common babyboomer response of helping their offspring through deposit assistance and handouts. Both are recognition that in an economy of ever higher prices relative to earnings it will become harder, and eventually impossible, to buy a home based on your salary alone. If prices are severed from earnings then it does not matter what you do, but simply who you are related to. Whilst seemingly melodramatic this is a genuine and very important volte face from the assumption of an expanding middle class and meritocratic opportunity that formed the bedrock of the post WWII, baby-boomer social contract. It is in fact a large step towards a return to a more 19th century, Victorian, social class system and economy. In this potential future society what you earn becomes irrelevant and housing wealth must be passed on through the family rather than bought via salary. The worries affecting the modern zeitgeist are reflections of this recognition. People worry about passing on (or receiving) their inheritance and of missing the boat because they realise that it is simply not possible to have house prices increasingly disconnected from

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earnings and have a meritocracy. We have to choose. Credit may seem like the answer, but it has its own problems, as outlined in the next section… Price vs. Rent ratio A final way to measure the relative cost of houses is to look at the price vs. rents ratio. This represents how much harder (or easier) it is to buy a house rather than renting it, regardless of how high inflation is or how much the average pay-packet has risen (it’s also broadly comparable to the price/earnings ratio commonly used to measure the value of stocks).

The price vs. rent ratio is a particularly interesting measure of relative housing cost because of the rent part of the ratio. The cost of renting a house or flat is a fairly good measure of broad housing demand in an economy. If there is a high demand for shelter rents will be high, as people will compete with other potential tenants and everybody will be prepared to pay more to get a roof over their heads. We all require shelter – it’s a fundamental need. Crucially, renting removes the complications associated with borrowing money. No bank will lend money to cover rent, so payments have to be made directly out of wages. This strips out the affect of credit costs, interest rates, and different banking systems. As societal demand for shelter increases renters will gradually pay more and more of their income in rent until finally they simply cannot pay any more and the poorer earners are forced to become homeless. With rents it is essentially simple –

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in a high demand society rents will be high and in a low demand society rents will be cheaper. Thus, a graph of house prices vs. rents adjusts, at least partly, for general housing demand. If overall demand was high the prices of both home purchases and rents would also be high, and thus the ratio of the two measures would not alter significantly. But the pattern illustrated in the graph above shows something very different. It can be seen that even by this measure the cost of buying a home in the UK is expensive relative to rents. This means that house purchase prices have recently increased more than rental prices, indicating that there has actually been a greater demand for buying a house than there has been for living in one. It therefore cannot be a simple matter of high demand. Tenants aren’t prepared (or aren’t required) to pay increased rents. In fact rents in the UK have been static or even falling since the turn of the 21st Century, especially in real terms. Yet house prices have risen beyond previous extremes. The price vs. rent graph thus suggests that recent house price rises are not a result of broad societal demand for shelter, but something unique to the purchase of a house. The obvious difference in the late 1990s and early 200s is the availability and cost of credit and the psychology of the boom.

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In short, you can argue some things about the current housing market, but it is simply not true to say that house prices are no more expensive than they have been in the past. Of course, very few people buy a house in cash. Most people take out a mortgage to do so. The comparisons illustrated above show that buying a house for cash today feels much more expensive than during previous periods. But they do not fully illustrate what it feels like to buy a house with a mortgage. Many people argue that, as interest rates are lower today than in previous years house prices can be more expensive… They say that buying with a mortgage feels no more expensive than in previous years. Is this true? Is cheap credit the answer?

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Myth 2: Interest Rates are lower, so buying an expensive house is just as easy as previous years “The key factor behind the doubling in average house prices since 1996 has been the shift to a low interest rate environment... Today, £5,000 of annual mortgage repayments buys £120,000 of mortgage debt, assuming a four percent mortgage rate. This is almost three times higher than the mortgage that could be afforded at 11.5%, the average mortgage rate over the 1980’s...It is no surprise therefore that gross mortgage lending is also rising at record levels.” Market Comment: FPDSavills Many commentators today argue that, as most people borrow money for a house rather than pay in cash, comparing the price of houses vs. earnings, inflation, or rents is misleading. They dismiss how much a property actually costs as irrelevant, going on to say that it only matters how much it costs to borrow the money to buy it. They claim that the true measure of affordability is solely the cost of servicing the mortgage payments - if the initial monthly payment is a high percentage of take home pay then the house is relatively “unaffordable”, if it is a low percentage of take home pay then the house is relatively “affordable”. Simple, no? By this “affordability” measure UK house prices are not at their peak. The current “affordability” of property is driven by the unusually low interest rate environment. The historic peak of mortgage “unaffordability” was in the late 1980s, when interest rates were 14% and nearly 60% of take home pay was needed to pay the monthly mortgage payments. As of the end of 2005 just over 40% was required. So mortgages are cheaper, right?

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Unfortunately, regardless of the metric used, it isn’t that simple. The “affordability” as defined above and used regularly in the media is an overly simplistic snapshot in time. It is a wheeze that gives no indication of how it actually feels to make monthly mortgage payments over the length of a mortgage, nor how quickly you might be able to afford to trade up. Declaring a mortgage as “affordable” because the 1st monthly payment of a $500,000 debt is a relatively low percentage of monthly salary sounds attractive. But a mortgage is for life, not just for Christmas. When you commit to a mortgage you are not just committing to the first few payments, but to a complete set of payments over the entire mortgage term (the term mortgage originally comes from “death-pledge” – a lifetime commitment). This matters. In fact, how those payments vary over time actually matters more to your future financial well-being than the initial payments. Not only that, but with millions of debtors in the economy it has a huge aggregate impact at a national scale. This is actually no secret – the basic premise is very well known. The banks and lending societies that sell mortgages know that the most important measure of worth is the entire stream of promised mortgage payments – remember, your payments are their profits! But banks don’t always want to wait years for that money to be paid, they prefer a profit

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today. So in recent years they have packaged up hundreds or thousands of these mortgages into complex structured finance products, pricing them based on the total repayments committed to and the perceived risk of the borrowers. In this way the agreed payments represent future revenue streams and profit that investors will pay for today. This practice enables the lenders to make immediate rather than deferred profit for their bottom line and provides yet more money to lend again. This was one of the big stories of the early 21st Century, during which time it was the market to be in – in 2003 the market for mortgage backed securities was $9 trillion in the US alone, and this doesn’t account for and the derivatives that rely upon them. All of this hangs off the total amount you have committed to pay. In contrast, the “affordability” described and used by the media is more realistically called “initial monthly cashflow”. This matters because it can make a prospective mortgage an attractive tease, but an appreciation of the impact of inflation and earnings growth is required to fully understand why all is not what it seems.

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Real vs. Nominal Interest Rates Whilst interest rate changes regularly make the news, concentrating solely on the headline rate can be very misleading. The true lifetime affordability of a mortgage is actually defined by the headline (or nominal) interest rate in combination with the inflation rate and the mortgage length. Banks, financiers, and businesses all know the importance of inflation and term, but unfortunately most of their customers do not.

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Inflation Anyone who lived through the 1970s will remember why inflation is important. In a high inflation economy the price of everything goes up rapidly. In the mid 1970s the rate of inflation was up to 25% a year, meaning that the cost of your shopping basket went up rapidly & the money in your pocket was worth less and less every month. Fortunately your wage would also rise, but this would often only happen yearly, or at best twice a year, and even then it would commonly lag the most recent price increases. So for many years it felt as if the cost of living was rising beyond people’s wages. People felt quite poor. This is the common perception of inflation. Whilst for many this understanding is fairly obvious there are also more subtle reasons why inflation matters not just to the weekly shop, but also to how it feels to be in debt and to pay a mortgage at different times.

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Real Interest Rates Matter Hee’s a quick test. If you are borrowing $200,000, is a 3% or a 10% interest rate better? The obvious answer is that the 3% rate is better, but in actual fact you are missing some crucial context for the decision. If the question turns out to be a comparison of different time periods (or different countries) and the actual inflation rate is 1% for the 3% loan and 20% for the 10% loan then is your answer the same? It shouldn’t be. Paying 10% interest rate on a loan is no problem if your wages are rising at 20% per year – you can easily pay off the yearly interest and have money left over just from your inflation linked pay rise. It’s almost free money. In contrast, it is much harder to make the payments on the 3% loan if your wages are only growing at 1%. The real interest rate takes into account how it feels to make the debt payments over time. It is calculated by taking the headline, or nominal, interest rate and subtracting inflation. In the example above the real interest rate for a 3% loan in a 1% inflation world is 2%, whilst the real interest rate for a 10% loan at 20% inflation is -10%. The smaller (or more negative) the number, the easier it feels to pay. Negative real interest rates are actually free money for the debtor. An understanding of real interest rates also highlights another possibility – it is possible

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to have different headline interest rates with the same real interest rates if the inflation rate varies as well. I.e. a 7% interest rate at 5% inflation, or a 20% interest rate at 18% inflation, or a 3% interest rate at 1% inflation all have real interest rates of 2%. For a given amount of money making the total long term payments of each of these loans will feel similar. It is their upfront costs, or initial cashflow requirement, that are different, and it is this that makes one mortgage seem more affordable than another. However, because the total amount paid feels the same for a given real interest rate it is not rational to bid up house prices just because the nominal rate, and thus initial cashflow requirement, drops This understanding matters. If someone told you that in 1976 interest rates were 16% you might be interested to know that inflation was nearly 20% at the time. The real interest rate was actually negative. In contrast, the interest rate in 2006 was 4% whilst inflation was officially 2%. Despite initial appearances it was actually better to borrow in 1976.

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Affordability vs Cashflow The distinction between affordability and cashflow is crucial. It is this difference that confuses many people into thinking a ‘70s mortgage is harder to pay than a modern one. Paying the 1st years payments on a 20% loan will take a large percentage of your pay during that year. The cashflow will be tight and most of your money will go towards paying your mortgage. However, once you have your first pay increase, which in a high inflation world will be substantial, it will become a lot easier. The cashflow eases, and becomes easier still after two years, and even easier after three. So whilst the initial cashflow is tough, the affordability over the lifetime of the mortgage is actually very good. The experience of the 1970s has even affected our culture. Most people who have started out in the housing market since the year 2000, or are hoping to start out today, have parents who bought their homes in the ‘70s. High inflation and high interest rates during this period meant that many home buyers of the time will remember that they had to make significant sacrifices and experienced very tight finances for the first few years of their mortgage. If you are borrowing money at 15% per year you can only borrow a relatively small amount if you want to have a chance of making the first year’s payments – the initial cashflow. But as shown, if your wages are rising significantly every year then it gets easier quite quickly. This is exactly what happened during the ‘70s. People took out mortgages with challenging cashflows in their initial years, meaning that they felt poor, but inflation and wage increases rapidly improved their lot. This meant that after a few years their debt was actually a very manageable percentage of their salary and their cashflow had considerably eased. At this stage they could choose to trade up to a larger property or simply have more money to spend. The concept of a housing ladder was born. Another example can be taken from the peak of the last “boom” in 1989 and 1990. At that time UK interest rates were between 13% and 14%. It was within this context that the all-time record first year mortgage payments (cashflow) were eating up 60% of take home salary. However, at the same time inflation was running at over 10%. This meant that if everything had stayed the same throughout the early 1990s it would have been approximately 10% easier to make the payments for each subsequent year of the mortgage (as earnings approximately track inflation). Thus it would have taken just over three years of a mortgage for the payments to drop from their record 60% to just over 40%, even without any change in interest rates.

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A low inflation environment is quite different. Today, people’s wages are not rising nearly as quickly as in previous years and real interest rates are actually not that much different from previous generations, but because the initial cashflow is much easier to pay people have declared that they can “afford” a more expensive mortgage. They are convinced that they can “afford” more debt. The experience of the baby boomer generation in 1970s and their hand-me-down learnings suggests that the right thing to do is to pay as much of your earnings as you can afford to buy a small property, as things will get better and you will be able to trade up quickly. In aggregate we have taken this 1970s strategy and applied it to today. Unfortunately, what they don’t tell you when they say housing is “affordable” is that low inflation lets debts linger longer. As wages are not increasing quickly the debt payments stay high as a percentage of salary. The initial payments may be no harder than in previous generations, but without the debt eroding benefit of inflation the later payments are considerably higher. It’s important to be clear about this: a new debtor today will pay much, much more over the life of a loan than ever before, even though the initial cashflow “affordability” tease looks better. As a result new mortgage debtors will have to work harder, for longer. Not only that, but they will find it harder to trade up as quickly as previous generations. This can be shown graphically. The graphs and examples illustrated below show that for a given debt, the same real interest rates (headline minus inflation) result in the same total payments over the length of the mortgage. The effect of lower inflation is to allow lower nominal rates. Whilst this makes the early payments cheaper (easier cashflow) it also makes the later payments more expensive. It’s important to remember that when you sign up to a mortgage you are buying the whole curve, not just the initial payments. Hopefully this alone illustrates why it is not rational to bid up house prices when nominal interest rates fall. They are not more affordable. By bidding up prices to the maximum of your ability to meet the initial mortgage payments as suggested by real estate pundits pushing “affordability”, you will pay as much in the early years as in a high interest rate environment, but much, much more in the later years than any other generation.

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So what should have people have done? The counter intuitive, but rational, thing to do during low nominal (but similar real) interest rates is to pay the same for a house as you would with high interest rates but make use of the cheaper initial payments and better cashflow to save and invest for the future so that you can more easily pay the more expensive payments later. Of course, this is not what we’ve been trained to do. Humans are not natural savers and the experience of the 1970s means that we are prone to take a high inflation strategy (“early payments are always high – but it gets easier”) and apply it to a low inflation world. This is a mistake The Implications of Mistaking Cashflow for Affordability Mistaking cashflow for affordablity has implications. It means that those buying today will have less spare money 5 years after the start of their mortgage than previous buyers, and much less spare money 10 years into the mortgage. As a result, trading up will be much harder too – effectively the rungs of the ”property ladder” have moved farther apart. Those that max out their cashflow by buying a one bedroom flat will find it’s much harder to get into that 3 bed house than they thought it would be. It is actually less affordable than they thought, and there will be a lot of disappointment.

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Unfortunately, that’s not all. It’s not just about trading up. Higher debt payments that linger for longer mean that borrowers cannot consume as much in the future when compared to previous generations. If you’re paying high mortgage payments in the 3rd, 5th, or 8th year of a mortgage then there’s clearly less spare money to spend on cars, holidays, houses, & televisions. Also, if you have taken out a significant debt that puts you into mortgage stress (>x% of gross earnings) then you will be under that financial stress for longer than ever before. Low inflation doesn’t just let debt linger longer, it lets financial vulnerability linger longer too. This means, at a minimum, that there has to be less consumption growth in the future than in the past. As private consumption is x% of the UK’s GDP then this will affect the entire country’s growth figures. Additionally, as mortgage payments will remain a large percentage of salary for longer the new generation of mortgage debtors will also be more vulnerable to financial shocks for longer. It is hard to predict what will happen in the next couple of years, let alone in 10 years, but in a low inflation world the borrower needs to think much longer term. Effectively the event horizon has stretched out from a couple of years to a decade. This may be a particular surprise to those that have committed to large debts and then want to start a family. Unexpected unemployment or personal tragedy will also have a greater impact on those still struggling with high debt, curtailing their spending or in a worst case meaning they will default on their mortgage payments. In aggregate, millions of debtors in this position will increase the vulnerability (and thus volatility) of the broader economy. Low nominal interest rates plus lax credit standards equals more volatility and vulnerability, not sustainability. This all adds up to a subtle, but very important point. By taking out a large mortgage today in a low interest rate world borrowers effectively commit a large percentage of their future earnings (and labour) and bring that spending potential forward. This is a huge amount of money that is effectively imported from the future to today, funding current consumption levels and supporting the elevated house prices. Of course, the mortgage borrowers aren’t the winners – they don’t get to keep the money. They give it to a home seller, who will then perhaps also take on more debt and buy a property farther up the ladder, repeating the process. Finally, the only people that really win are those in their final houses or those that bought multiple investments some time ago. It is these people that get to spend the money. Many others feel rich based on their perceived paper wealth. This wealth is sometimes accessed through financial instruments such as

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Mortgage Equity Withdrawal, which is basically more money imported from the future sale of a house and spent today. Others just like to think their paper wealth is real. This, in economic circles, is called asset illusion (until you sell it, it isn’t actually worth anything). This relatively complex concept of importing money from the future actually illustrates a crucial component of the modern economy. As earnings have failed to rise fast enough we have financed our current economy and its recent growth by importing consumption from the future to provide a lifestyle for some today. You should be able to see how this cannot continue indefinitely. It requires ever more credit, at ever easier or longer terms, and ever more willingness to take on potentially crippling debt in an increasingly volatile world. In short, it’s a problem.

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To summarise, a person buying today will have to invest many times more labour, many times more actual clocked-on work effort, to pay for the roof over their head than any other buyer at any other time. It is not more affordable, and the apparent initial cashflow can tease borrowers into debts that will affect their future financial wellbeing and consumption potential in the future, along with the sustainability of the economy.

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Is There a Better Way? In the early, darkest days of the recent credit crunch a long term solution to this problem was actually suggested. Indeed, perhaps surprisingly, the solution has been previously tried and tested. It is simple: if mortgage lenders were to return to traditional levels of earnings multiples, perhaps 3.5x or even 4x salaries for a new mortgage, then borrowers would not be saddled with excessive long term debts. This is what in fact happened in the 1950s in the UK, when interest rate and inflation conditions were actually quite similar to today but bank lending practices were more “restrictive” and there was no damaging credit-based housing bubble. In this 3.5-4x earnings mortgage system the total loan payments of new debtors would stay similar to previous generations as a percentage of lifetime earnings. Careful management of the lower payments in the early years/higher payments in the later years issue would even enable these new debtors to trade up more regularly, keeping the traditional housing ladder. This would be most easily facilitated by encouraging new mortgage holders to save or invest the early “excess” instead of spending it, ensuring that it is available to offset the later, higher payments later. A first step in this solution would be for the government to educate the population about this issue, and the nature of long term debt payments, and as part of this effort require that banks provide dedicated savings solutions that help debtors save, perhaps even with tax incentives. Of course, this will never happen. The incentives that currently exist in the market place make this extremely unlikely. For starters, it would hit the bottom line of banks today – they make profit based on the size of their customer’s debts (the more the better) and they are incentivized on a short, yearly schedule for staff bonuses. It’s not just the banks though - a 3.5x multiple would ensure that the current decline in house prices would continue until they hit more sustainable levels. This would hit people’s perceived wealth in the short term. Most property owners in the current marketplace suffer from Asset Illusion, in that they perceive they are richer than they necessarily are based upon their perception of their paper worth. They feel rich. Even though for most (i.e. anyone planning on moving up the ladder) price falls will make them better off, the perceived pain of deflating house prices will dissuade them from this solution. Furthermore, it will directly hit the bottom line of estate agents, surveyors, and buy-to-let investors. All of these groups will join a chorus of disapproval in the popular press and are more than capable of swaying public opinion, which of course will put pressure onto elected officials, or more importantly, those that want to be elected or re-elected. The calls to

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address the issue would be loud. Unfortunately, for many participants in the market place the sustainable path is not the path that makes them any money or provides any power. The burden of future payments is almost exclusively on the young, who vote little and are generally unaware. An alternative solution would be to lower the term of mortgages based upon the interest rate. When nominal rates are low, and early cash-flow relatively easy, then mortgages could be of shorter term, pushing up early payments but decreasing the lifetime burden and allowing the debtor to pay-off, and trade up.

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Myth 3: It has always been tough to buy your first property, but you pay off some of the mortgage in the first few years and then you trade up. It’s no different today. This is a common perception, but unfortunately it is not true. As a quick test: what percentage of a repayment mortgage do you think is paid off in the first 5 years, or 20%, of the typical 25 year loan term? Let’s assume the loan is for #200,000 and the interest rate is 7%, which approximates the mortgages available in the UK today (July 2009). Most people would guess that about 20% of the loan, or 40,000 pounds, is paid off in this time. This is a reasonable assumption and makes intuitive sense, as we commonly assume that debt is paid off evenly over the length of a loan. However, it may be a surprise to discover that in the early years of the mortgage most of the ~#1400 monthly repayment in this example goes towards paying off the total loan interest (which is the bank’s profit, which they want as soon as possible), rather than the actual debt. The majority of the debt repayment is actually paid towards the end of the loan. This is called loan amortisation (or amortization if you are American), and as a result you will have paid off not #40,000, but just #18,000 after the first 5 years of this mortgage, or less than 10% of the debt.

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In reality, as discussed in more detail in the previous section, the property ladder was historically based not upon paying off the capital of the loan, but instead upon high inflation, and thus high earnings growth, eroding the debt and payments as a percentage of your salary. For instance, in the 1970s, high inflation drove high annual wage increases, meaning that the burden of a given debt relative to income decreased rapidly over the years. At 20% wage inflation, as occurred during the 1975, the burden of a debt that took 60% of take home pay in the 1st year took just 50% in the 2nd year (i.e. the same as 5 years today), 41% in the second year, & 34% in the 3rd year, by which your payments would have approximately halved relatively to salary and you may have been ready to trade up. This would have occurred even though a 20% interest rate on the loan you would meant that you would have only paid off ~1% of the actual debt. In contrast, if wage growth is 2%, as today, then at the end of the 3rd year of the loan an initial debt burden of 60% of take home pay would still require 56% of take home pay. This is clearly a significant difference. It is inflation, not debt repayment, that enabled past mortgage holders rapidly trade up.

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