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Big_Al

Do Lower Irs Really Make Properties More Affordable Now Than Previously When Rates Were Higher But Prices Were Lower?

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I've noticed that bulls have used the rationale that lower interest rates means mortgages are more affordable and therefore a crash is less likely.

I've been pondering this one for a while and decided to run some figures just to see how true this is and came up with some interesting results.

average property = £180,248 (at the end of 2004, ODPM figures for 2005 not published yet).

Repayment = £951.78 (assuming 5% deposit is paid, using current base rate of 4.5%)

Looking back to when average prices were half as much...

average property = £81,774 (end of 1998 according to ODPM)

Repayment = £574.09 (assuming 5% deposit paid, base rate of 7.5% which is the highest it reached in 1998)

So although rates are lower now it is actually costing more because of today's larger mortgages.

I think salary increases needs to be built into this, so I think the 574.09 in todays terms would be:

119.5/89 (increase in average earnings) * £574.09 = £770.83

i.e. still £180 lower than the £951.78 being paid today.

Can anyone pick holes in this?

AL

Edited by Big_Al

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The Bulls are actually right on this one, and the reason is the way we handle mortgages.

The way mortgages work is they work out how much you have to pay, say £200k. Work out the length of time, say 25 years and do compound interest, to get (at the momnet say) £400k. They then divide that by the number of months you have in the mortgage to get the term.

Now, you are going to be earning a lot more towards the middle and end of your mortgage than you are now, because a) you should have a better job and B) inflation. Mortgages get *easier* every year to pay them.

The problem comes if there is high inflation (and thus high interest rates). What happens then is this £400k which is generated with low rates becomes £600k over the life of the mortgage. What is important is that the *real* money you are paying hastn't changed, just the nominal interest and inflation rates are higher.

But what does this mean in mortgages, it means the early monthly payments are very high, too high for someone to pay initially. The mortgage is just not affordable, despite the fact that the real value hastn't changed, all that has changed are nominal values.

So the bull's are right here. Low nominal interest rates and inflation rates do allow people to take bigger mortgages, just becase of a quirk in how mortgages are made.

To fix the problem in high nominal interst rates would be easy, mortgage payments should be adjusted with inflation - ie you pay £1000 the first year, £1080 the 2nd year etc. Then nominal rates would make no difference - but for now, they do.

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Guest prudence

Would you rather borrow £200k at 5 percent or £100k at 10percent? Whatever happens to IRs the 200 k debt has to be repaid at some time. IRs at 5 percent - not that high by historic terms so could go higher. £100k - it has bought you the same asset for half the price. The initial loan that has to be repaid is only half. IRs at 10 perecent - reasonably high level so the chances of them falling are fairly high. (This is a very simplistic argument but still makes sense).........

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To fix the problem in high nominal interst rates would be easy, mortgage payments should be adjusted with inflation - ie you pay £1000 the first year, £1080 the 2nd year etc. Then nominal rates would make no difference - but for now, they do.

What you're talking about is basically a "negative amortisation" mortgage where the amount owing is adjusted upwards every year -- automatically MEWing to reduce your mortgage payments. They're rather risky because if house price inflation doesn't meet expectations you have to stop doing it and suddenly start to pay the full amount. Also, I don't think they're available in the UK, although they are in the US.

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Al

you are correct the acctual size of loans has a direct corolation to its cost, not only current interest rate. However if UK base rates are reduce this year instead of kept the same or increased, its main effect will be to temp a few more misguided people in to the market at the wrong time. Below is a real example.

1984 1 bed flat price 24k, earnings 8k: Price to salary ratio X3

Same flat same job

2004 1 bed flat price £125k, earnings 16k: Price to salary ratio almost x 8

so even if intrest rates are much lower than historical average, its a challenge.

I posted this on another thread.

The .25% drop last year was a mistake. The BOE wise men realised this shortly after. However having dropped rates when inappropriate, to increase them will mean publicly admitting they were wrong. There will also be political pressure for another reduction over the next 3 months as the VI feel the squeeze. What is probably needed is another .25% increase in April or May. What we dont need (for the greater good of the country) is another reduction for at least 6 to 8 months. What we will probably get is no change for at least 6 months, as that will be the easiest one to justify.

This is JMO and should not be construde as Investment advice.

Pablo Silver or Lead.

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Would you rather borrow £200k at 5 percent or £100k at 10percent? Whatever happens to IRs the 200 k debt has to be repaid at some time. IRs at 5 percent - not that high by historic terms so could go higher. £100k - it has bought you the same asset for half the price. The initial loan that has to be repaid is only half. IRs at 10 perecent - reasonably high level so the chances of them falling are fairly high. (This is a very simplistic argument but still makes sense).........

Yeah but interest rates don't work like that. You are talking about nominal interst rates, these are irrelevant. You need to consider the real interest rate which is the interest rate - inflation. This is generally pretty constant.

You are also suggesting that IR solely determine house prices, which is not the case. They have some affect obviously by having lower nominal interest rates, bigger houses are affordable but that is only one aspect of the story. People are still choosing to spend more.

What you're talking about is basically a "negative amortisation" mortgage where the amount owing is adjusted upwards every year -- automatically MEWing to reduce your mortgage payments. They're rather risky because if house price inflation doesn't meet expectations you have to stop doing it and suddenly start to pay the full amount. Also, I don't think they're available in the UK, although they are in the US.

I have heard of these but if you are MEWing then that is not what I am talking about. What I am talking about is a mortgage where you pay the same "real" money towards the mortgage every year. Ie you pay £1000 this year but £1030 next year, assuming 3% inflation. That is the same £1,000 being paid back every year. There is no MEWing going on there at all and it does not require house price inflation either it is simply a way of making the mortgage payments the same every year, as opposed to now where every year the mortgage payment gets easier and easier (assuming interest rates don't change).

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I've noticed that bulls have used the rationale that lower interest rates means mortgages are more affordable and therefore a crash is less likely.

Yes to the first part. Of course low IRs make payments more affordable.

However, I think that it makes a crash more likely because you have a larger debt burden and hence are sensitive to even small increases in IRs, especially people w/ variable rate mortgages. When I had a mortgage I was told to make sure I could afford payments if IRs reached 8%, but then the previous crash was very much with us and the lenders weren't as keen to give out money.

I very much doubt that we have moved into a new low inflation economy. With oil at $65 a barrel, for how much longer can IRs stay where they are? We're below the long term average.

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Big_Al,

I liked your analysis so much I made a graph based on your maths for the past few years. I haven't got the full data for 2005 so it is not included, and the interest rates are the year end interest rates.

I hope the graph has attached as it is the first attachment I have made.

Graph.JPG

post-3472-1136722350_thumb.jpg

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Now, you are going to be earning a lot more towards the middle and end of your mortgage than you are now, because a) you should have a better job and B) inflation. Mortgages get *easier* every year to pay them.

Is that right? Aren't you missing one of the key points here: In a low inflation/low interest rate environment, inflationary pay rises are very small. That's a key part of the argument isn't it? In the past, when we had high interest rates and high wage inflation, 10 years after a mortgage was taken out, even by doing the same unpromoted job, a person's mortgage would have shrunk dramatically as a fraction of their (wage inflated) salary. That effect is much reduced in a low wage-inflation / low interest rate environment, so that at the end period of a mortgage, a person's unpromoted salary is much closer to that when the original mortgage was taken out, and therefore the total fraction of their salary over the life of the mortgage that went on mortgage payments is bigger. That is surely the key pivotal point of this isn't it, and you've missed it I think.

The point about bigger wages through getting a better job doesn't come into this surely, because that is independent of interest rates and inflation rates.

Think you've missed the point here....

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it would only make sense if that LOW 5% was for the length of the mortgage.

pity then you can sign up at 200k at 5% (£951.00) and shortly find yourself lending 200k at 7.5% (£1379.00) by 2008.

i havent also seen wages really rise in the last 5 years. you cannot count on wage inflation to catch up within the next 10 years. right now a mortgage is a hard, risky slog.

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The point about bigger wages through getting a better job doesn't come into this surely, because that is independent of interest rates and inflation rates.

I think the increase in wages argument (excluding inflation) worked when people bought in their early 20's as, on average, you tend to find better jobs as you get older. I believe that the converse applies nowadays with an average FTB aged 34.

A 25 year mortgage would end when you are 59. For many people it proves difficult to find the same level of work in your mid 50's onwards so what was a reasonable level of repayment aged 35 may be impossible aged 55, even with 20 years compound inflation. If you've bought at the lower end of properties matters become worse as you have little scope for downshifting.

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I've amended the title of this post to clarify where I was going with this.

Padders, I don't agree with your method of calculating a repayment mortgage as the interest payable reduces as the capital reduces on a monthly basis - although the payment itself stays the same (assuming IRs don't move).

I do agree that payments become easier if there is wage inflation but as RFD pointed out this has been low these past few years so payments stay high and the capital amount also stays high.

IMP, couldn't read the graph that well, could you perhaps explain.

AL

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I've amended the title of this post to clarify where I was going with this.

Padders, I don't agree with your method of calculating a repayment mortgage as the interest payable reduces as the capital reduces on a monthly basis - although the payment itself stays the same (assuming IRs don't move).

I do agree that payments become easier if there is wage inflation but as RFD pointed out this has been low these past few years so payments stay high and the capital amount also stays high.

IMP, couldn't read the graph that well, could you perhaps explain.

AL

What bit exactly don't you "agree" with? What you have said is accurate but in now way contradicts anything I said.

Your mortage payments are a function of the capital and the nominal interest rate. They *should* be a function of the capital and the real interest rate, then you wouldn't get this situation that low nominal interest rates encourage further borrowing.

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I guess it depends on the inflation in your area..

I live in Devon and here we have seen between 200% and 300% inflation.

A house in my parents estate was worth

£98,775 beteen 2000 and 2001 whne several sold for just below £100,000

Peak value was £250,000 in 2004 although many have been on the market and not sold..

Look at the BBC mortgage calculator..

http://www.bbc.co.uk/homes/property/mortgagecalculator.shtml

so at £98,000 it would have been

£765.04 ma month at 8% for a repayment.

The peak property sold in 2004 £250,000 at

£1264.04 at 3.5% for a repayment..

It was never really 8% and it was 3.5% only for a short while..

so I have made the cheaper price as expensive as it could have been then for interest rates.. and the peak price as cheap as it could have been..

the £250,000 would be £1478.17 at 5% the average mortage today..

guess that is why the three at that price have not sold in all the time they have been there.... a long time approaching a year for a couple of them..

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From the good old Economist...

http://www.economist.com/opinion/displayst...27&no_na_tran=1

A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries' membership of Europe's single currency—though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.

Anyone care to expand?

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Is that right? Aren't you missing one of the key points here: In a low inflation/low interest rate environment, inflationary pay rises are very small. That's a key part of the argument isn't it? In the past, when we had high interest rates and high wage inflation, 10 years after a mortgage was taken out, even by doing the same unpromoted job, a person's mortgage would have shrunk dramatically as a fraction of their (wage inflated) salary. That effect is much reduced in a low wage-inflation / low interest rate environment, so that at the end period of a mortgage, a person's unpromoted salary is much closer to that when the original mortgage was taken out, and therefore the total fraction of their salary over the life of the mortgage that went on mortgage payments is bigger. That is surely the key pivotal point of this isn't it, and you've missed it I think.

Yeah, but this is why when you have high nominal interest rates people could only afford 3x multipliers, if not less because the payments at the start where very hard, but got a lot easier when wage inflation happened and the real interest rate dosen't change. This is exactly my point.

You have two options:

a) High nominal interest rates, low income multiplier mortgages, inflation erodes the cost of the mortgage after the first very hard few years

B) Low nominal interest rates, high income multiplier mortgages, inflation does not erode the cost of the mortgage - it never gets much easier to pay of the mortgage.

The point about bigger wages through getting a better job doesn't come into this surely, because that is independent of interest rates and inflation rates.

The point about the better job is relevant. Lots of people get mortgages that they struggle with for the first few years knowing they will get pay rises and the mortgage will become easier. If however you are credit constrained because you are under option a) then you can't take out a bigger mortgage than your current income because in the short term you couldn't pay it of. Under B) you can.

Think you've missed the point here....

I don't believe so. You may not understand my point or I may not be explaining it well, but what I am saying is not controversial. Any economics or accounting text book will explain - perhaps a lot better than I do.

it would only make sense if that LOW 5% was for the length of the mortgage.

pity then you can sign up at 200k at 5% (£951.00) and shortly find yourself lending 200k at 7.5% (£1379.00) by 2008.

i havent also seen wages really rise in the last 5 years. you cannot count on wage inflation to catch up within the next 10 years. right now a mortgage is a hard, risky slog.

EXACTLY. That is the danger of the current situation (B). It might not stay like that. People have taken these huge mortgages because the current payments are just about affordable but they are not going to go down with inflation like they did in a, (even if inflation rises, its the point you get the mortgage that matters) - if we go from b to a, everyone with mortgages is shafted.

A 25 year mortgage would end when you are 59. For many people it proves difficult to find the same level of work in your mid 50's onwards so what was a reasonable level of repayment aged 35 may be impossible aged 55, even with 20 years compound inflation. If you've bought at the lower end of properties matters become worse as you have little scope for downshifting.

In the "olden" days, people would repay their mortgages before 25 because the payments became smaller and smaller (because they where fixed at the rates 10,15,20 or whatever years ago and are not adjusted for inflaton). Because people have taken payments at such low interest rates now and such large capital repayments, this will not happen - so in some senses you are right.

Still, those people working in the city who are 25 and earn £35k say as lawyers, will be earning £100k by the time they are 30 if not more. For them, its still a pretty safe bet.

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guess that is why the three at that price have not sold in all the time they have been there.... a long time approaching a year for a couple of them..

and i guess thats why your stuck in a rental rut and cant buy and cant establish your home/life.?

if the figures added up we wouldnt be on this forum we would be just getting on with it like everyone else.

i think we have around a 2-3 year wait.

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A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries' membership of Europe's single currency—though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.

This is exactly correct. When you look at the cost of a mortgage, all the matters is the real interst rates. 10 interest rate and 5% inflation is exactly the same as 5% interest rate and 0% inflation. (The caveat to that is you have to be able increase your wages infline with inflation, otherwise the 2nd of those might be better if you are in a weak wage barganing position).

My argument istn't about the total cost of the mortgage its about the ability to take out a bigger mortgage and this is where nominal rates do matter, which I explained in my first post. Its these low nominal rates that are party responsible for the HPI because people have been able to borrow that much more (this is why 5x income, 6x income are possible). The problem is people in-debt themselves for the full 25 years, when you have high nominal interest rates, you pay more of the real debt of a lot quicker so come year 15 or so you are paying a lot less real money.

That's the problem for people buying now, their mortgage really *is* for 25 years.

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Guest wrongmove

This is exactly correct. When you look at the cost of a mortgage, all the matters is the real interst rates. 10 interest rate and 5% inflation is exactly the same as 5% interest rate and 0% inflation......

.....That's the problem for people buying now, their mortgage really *is* for 25 years.

I entirely agree with these statements Padders, especially the final line. Maybe one day, the typical punter will latch on to what you are saying here, but it seems that all most people care about is the inital mortgage payment on their loan - i.e the nominal rate. If they are cautious, they will fix the IR. If not they will take a chance on a floating rate.

But where does this leave FTBs like me ? I would much rather have a small loan at a high nominal rate, but we do not have high nominal rates, and they do not look likely in the forseeable future. If if inflation took off, a relatively small rise in IRs should be enough to choke it off. I really can't see 10% or even 8% any time soon.

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Guest prudence

Yeah but interest rates don't work like that. You are talking about nominal interst rates, these are irrelevant. You need to consider the real interest rate which is the interest rate - inflation. This is generally pretty constant.

You are also suggesting that IR solely determine house prices, which is not the case. They have some affect obviously by having lower nominal interest rates, bigger houses are affordable but that is only one aspect of the story. People are still choosing to spend more.

I have heard of these but if you are MEWing then that is not what I am talking about. What I am talking about is a mortgage where you pay the same "real" money towards the mortgage every year. Ie you pay £1000 this year but £1030 next year, assuming 3% inflation. That is the same £1,000 being paid back every year. There is no MEWing going on there at all and it does not require house price inflation either it is simply a way of making the mortgage payments the same every year, as opposed to now where every year the mortgage payment gets easier and easier (assuming interest rates don't change).

you seem uninterested in the size of the capital debt. I. onthe other hand, think it is very important.........

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you seem uninterested in the size of the capital debt. I. onthe other hand, think it is very important.........

I totally agree with this and I think this was what I was trying to show in my original post. Even though interest rates are lower now, having to repay a larger amount of capital is a greater burden for people and lower interest rates has not negated this problem.

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I totally agree with this and I think this was what I was trying to show in my original post. Even though interest rates are lower now, having to repay a larger amount of capital is a greater burden for people and lower interest rates has not negated this problem.

Totally agree with this and was about to make the same point. The fact that bulls have to trick people into thinking a mortgages is cheaper by spouting "lower rates! lower rates!" is pretty sly. The fact is we are paying back way way more in real money. Like has been said so many times, the debt is real, the house price is opinion.

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low cost of money is a key part of money illusion.

for most people yes it makes them more "affordable" but only when rates are low.

when rates rise the illusion vanishes along with their house.

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you seem uninterested in the size of the capital debt. I. onthe other hand, think it is very important.........

I have no idea why you would think that, certainly from nothing I said. All I was talking about is why people are able to take out bigger mortgages (5x income) because of low nominal interest rates. I hear lots of bears suggest that its all about x times the income, well with low nominal interest rates it is possible, and sustanable to take out bigger loans. An incredibly bad idea (the mortgage for life thing I mentioned) but possible and sustanable. That is what people are doing.

Clearly the more you borrow the more you have to pay back, thats obvious but has nothing to do with any of the points I have been making. And to suggest that property prices are only high because of low interest rates is wrong as well; while low (nominal) interest rates have an affect by allowing people to borrow more, this is hardly the only reason property prices are high.

But where does this leave FTBs like me ? I would much rather have a small loan at a high nominal rate, but we do not have high nominal rates, and they do not look likely in the forseeable future. If if inflation took off, a relatively small rise in IRs should be enough to choke it off. I really can't see 10% or even 8% any time soon.

This is good though. High inflation and high interest rates are bad for economies. The problem now is people don't realise that their mortgage payments are going to remain a significant portion of their income because the monthly repayments real cost is not going to decrease very rapidly (3% per year as opposed to say 7%). Once they realise this they won't be prepared to take on such big mortgages. Clearly when the crash/sustained fall or whatever you want to call it happens, there will be more people unable to make these repayments as well.

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