Home Loans in the UK - Time for Some New Ideas
Aug 03, 2006
David Miles (London)
Average house prices in the UK have more than doubled since 2000. Incomes have not increased by anything like as much. As a result buyers — and particularly first-time buyers — are having to borrow far more relative to their incomes than was the case in the past. For recent first-time buyers in the UK the average ratio between purchase price and incomes is about 4.5 — ten years ago it was 2.9. Mortgage advances relative to incomes are up sharply — and on average are now about 40% higher than was typical ten years ago. At the same time, most first-time buyers are now having to find a somewhat higher proportion of the purchase price as a deposit, and with prices having risen so much, this means that many buyers are struggling to afford even the most modest homes. All this is happening against a backdrop of very sharply rising personal insolvencies and increased bank write-offs of bad debts. Thus far, most of the defaults have been on unsecured lending — credit card debt and overdraft lending. But there has also been an increase in the rate of possession orders taken out by lenders as a first step towards possible re-possession of homes from owners unable to make mortgage debt repayments.
In this environment, the type of mortgage that has been typical in the UK for many years becomes increasingly unsuitable for many aspiring home owners. The typical UK mortgage is a variable-rate debt contract (or one where the rate is fixed for a small part of its life — typically two years or so); the loan usually represents a high proportion of the purchase price — often 90% or more of the value of a house — but the liability is not linked to shifts in the value of the property. This loan contract means that first-time buyers are taking a highly leveraged investment in a highly non-diversified portfolio of residential property — the concentration of investment in one property is, in itself, pretty extreme when viewed in the light of standard portfolio theory. And the protection against interest rate fluctuations created by fixing the rate for just two years or so is limited in a world where no-one knows where short-term interest rates will be a few years down the road. What kind of financial contract would offer a better way to deal with affordability and risk issues for many first-time buyers? And could it be offered on a commercial basis? Some desirable features of a loan contract are: 1. That it makes buyers less exposed to sharp swings in the value of the specific property that they buy and makes the value of the loan reflect, to some extent, shifts in the value of the home that is its collateral. 2. That the burden of repayments on the loan is not fully exposed to shifts in interest rates which can cause severe problems to those who might only just be able to manage payments at current levels of interest rates. In the light of this, equity share (or equity loan) contracts — where a lender effectively takes an equity stake in a home and gains exposure to movements in the value of the property — are promising. The government had various initiatives in this area. But those schemes have an element of public subsidy and, as a result, are likely to be targeted at specific groups rather than be available more widely to all potential borrowers. This is why it is interesting to ask whether financial contacts that have these features can be offered on commercial terms. Since the economic advantages — particularly in terms of risk-sharing between lenders and home owners — of having a contract that has these features are potentially substantial, there is every reason to believe that they can be mutually beneficial and therefore commercially viable. The idea behind the schemes is simple: some significant part of a loan will have a repayment value that is a proportion of the value of the home. The interest rate on that part of the loan whose outstanding balance moves in line with the house value will be low — a deal of this sort recently offered sets that rate at a fixed 2.99% for the life of the loan. This contract means that house price risk is shared, and that on a substantial element of the overall loan the cost of funds is both low and fixed for the life of the loan. Because of this, both the current cost of, and the risks generated by, loans that are a high proportion of current income can be less than with conventional loans. In exchange for getting a lower interest rate and some insurance against house prices falling, home owners will give up some of any house price appreciation. This will not be right for everyone — but might be attractive to the risk averse struggling to get onto the housing ladder. As a result of this sort of lending, securities can be created that allow investors to receive a stream of income that is linked to overall house price inflation. These could come to represent a useful alternative to existing index-linked bonds that create a return that is some fixed amount in excess of consumer price inflation. A security that generates a fixed return over UK house price inflation is likely to be one that many long-term investors would see as a useful addition to the existing pool of securities.
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