I struggled a bit with a post this week. Week…that’s my ideal goal, write on a weekly basis but as you can see, I am usually behind schedule.
I am preparing a post around the “glidepath” but I cannot find the right angle to write it. Plus, I got busy with the followings:
- @wifeyalpha is posting a ton of interesting research papers
- Our family did a +1 a month ago and we are still adjusting to the new routine(s)
- the NBA finals
- I run a leveraged portfolio and the cost of debt is raising faster than I expected: should I de-leverage? I want to take an informed decision but I do not want to wait until maybe it is too late, so I did research on that
- …and I still have a job that requires a bit of attention
Then this morning I read this post on Monevator about rising mortgage rates and…great inspiration about my experience.
A quick introduction to mortgages in the UK
Unlike in Europe and the US, where you can sign a 30-year mortgage that maintains its conditions for the whole life of the contract, in the UK any mortgage has a “teaser” rate for the first part and then switches to floating plus a giant spread. In other words, when I was living in Luxembourg I got a mortgage where I was paying ECB rate + 125bps (I think…) for 30 years: the spread and conditions would not change until the mortgage was repaid. Here in the UK, I got a 28-year mortgage with the following conditions: BOE rate + 89bps for the first two years and after that BOE rate +375bps.
In practice, in the UK you choose the first period of the mortgage (fix or floating for a maximum of 10 years) and then, when it expires, you can re-negotiate it, with the same bank or another one, before the ‘punishing’ spread kicks in. I do not know why the system is designed this way, it seems that soon we would be able to get a 30-year ‘European style’ mortgage also here, better late than never…
This framework reminds me of the ARM subprime mortgages that originated the GFC, why an entire system is designed like that is beyond my understanding. The good news is that UK mortgages are portable, meaning you can take your existing mortgage when you change home. This is particularly valuable if your current mortgage has a lower rate compared to a brand new one; unfortunately, the fact that you can fix a rate for a maximum of 10 years instead of 30 makes this option (way) less worthy.
The mortgage golden rule
At any given time, the market’s forecast of what the benchmark floating rate will be in the future is reflected in the forward benchmark curve. In the case of a mortgage, that benchmark can be the Central Bank rate. Using this forward benchmark curve, a bank determines fixed rates as the total value of the fixed rate flows will be equal to the value of expected floating rate flows implied by the forward benchmark curve.
In short, this means that at day 0 the borrower would have the same total expected future costs whether they choose a fixed or floating mortgage…if actual future rates follow today’s market expectations. The floating borrower pays less at the beginning and more in the later stage of the loan but if you believe market assumptions are correct, both choices are equal.
But…
To take a lengthy commitment, let’s say 10-year fixed, market participants want to be rewarded because they are taking more risk compared to shorter investments. In other terms, if you want to know today how much your debt is going to cost in 10 years, you have to pay an “insurance” premium. This market preference is reflected in the fact that the yield curve is typically upward sloping:
This is why floating mortgages are cheaper than fixed ones, because the borrower saves this maturity premium in exchange for uncertainty. Based on today’s information, if you want a higher probability of lowering your future total mortgage costs, take a floating mortgage.
How to manage uncertainty
Consider what is happening today with inflation and Central Bank rates and you can understand why a floating mortgage is a jump into the unknown.
The best way to manage uncertainty is to build a sensible margin of error in your considerations. If the monthly payment on your floating mortgage is close to the maximum you can afford in your budget, you should not take a floating mortgage. This event is prevented, to a certain extent, by the current UK regulation: the lender has to ‘stress test’ the borrower’s capability of paying the mortgage if rates increase by 3%. Even if the bank is fine with lending you money with a floating rate, you should apply your own judgment because:
- two years ago I would have considered a 3% stress way too conservative. In today’s environment, it might be…too lax? Look how fast the FED is raising rates. You are the only one that knows where is the breaking point in your budget.
- the bank stress test is based on your current salary. They do not know how likely you (or your partner, if you are both signing on the loan) can get a promotion or lose your job. These variables are more important than any regulatory-set stress test.
A way to build that margin of error is to provide enough equity when you buy the property. From a purely financial point of view, there is a sweet spot for leverage: borrow too much (above 80%) and you will waste a lot of money in costs, borrow too less (below…50%?) and you are leaving some money on the table.
Another important aspect of the margin of error. Do not spend it, invest it. Let’s say that when rates are low, your mortgage monthly payment is £1000 and in your budget, you can sustain a mortgage payment of £1400. You should save, and ideally invest, that £ 400 extra. If rates rise, your monthly consumption budget will not be touched (you can go on and live like before); if they do not, after some years you will have additional funds to do whatever you want: retire earlier, buy a bigger property, go on an extra holiday.
Focus on what you can control
Whether you choose a fixed or floating mortgage, the bank will charge you a ‘benchmark rate plus a spread’. You cannot do anything about the benchmark rate (unless you become a Central Banker, in that case please write to me…but not like my boss, who is called Andrew Bailey but he is not that Andrew Bailey) but you can push the spread lower. How?
Borrow less. The spread is linked to your personal credit risk; the less you borrow compared to the value of the property, the less the bank will see your transaction as risky. This means you might look at something smaller / in a worse position than your ideal target: sometimes is worth it, if that extra room was meant to be exactly that, extra. Based on market conditions, sometimes the spread difference between a 95% LTV and 80% LTV is not that big; or a 95% LTV is the only way for you to jump on the real estate ladder. In those cases, channel as much savings as you can towards your equity to bring it to at least 80%.
Shop around. Getting a mortgage is a painful process that requires piles of documents while most banks use the same criteria anyway, but asking multiple companies is still worth the effort. Find a broker that would do it for free (they get paid by the bank). Unlike finding a good plumber, this chore might save you a relevant amount in the long run.
Build a relationship with a bank. Forget about the numbers, banking is a relationship business and if they see that you are responsible with your money over the years, they would be more willing to give you a loan. If you want to look at the numbers, banks have set criteria to cluster their clients: for example, Barclays puts you in their Premier Banking tier if you have a salary higher than £70k or you have £100k invested with them. Premier clients get better services, like lower mortgage rates (on selected loan types and maturities).
Be flexible
Wait. If rent is not choking you, you can put aside something extra towards your savings/future equity. Buy when prices are going down. Yes, I know this might sound impossible but I bought two apartments and in both case I bought at a 20% discount on the listed price. The listed price is just where the negotiation begins, most of the time is up but sometimes down. I bought my first apartment in Luxembourg after the Great Financial Crisis, when the sentiment was as low as Boston Celtics fans now. I bought my second apartment in London in 2019, when you could bargain because everyone was scared about the prospects of London after Brexit (curious enough, later England became indeed a shitty place to live after Brexit, while real estate prices…rocketed back up. Sometimes you are right for the wrong reasons). Those purchases were less than a decade apart: these circumstances are not frequent but not super-rare either, you just have to be patient. I sold my apartment in Luxembourg because I wanted to buy something in Switzerland when I moved in…and spent four years looking and looking without finding a deal.
Do not fall in love with a particular property. Try to think in terms of pros and cons. More space means a bigger surface to clean and maintain. My apartment has no private garden but I have a very cool park just across the street: I often joke that I have a huge garden and someone that maintains it for me for free (not exactly, thanks to those lovely council taxes). I cannot watch my kids playing outside while sitting on my chair sipping coffee, I have to dress to cross the street (it is still London, if I go in my PJ no one would say anything but still…), so it is definitely not as having a private garden but I am fine with the trade-off. I definitely miss the bbq but…just in an ideal world? I rarely invite people over anyway and I would not do it just for myself, since my wife does not like meat, so it feels again like those things that you think you miss while in reality you are just fine as you are.
My experience with mortgages
When I bought my first apartment in 2011, I choose a 30-year floating mortgage mainly on the back of the mantra “Europe is the new Japan”. I had a great conviction that we would not see rates in Europe above 3% again, most likely we would never see another rate increase 😉 Even if history proved me right (so far), it was a cocky and not brilliant decision: I am not 100% sure but the contract was most likely floored to 0, meaning I had little upside (the difference between 0 and the fixed-rate less the spread, probably 150bps) and a lot of downside in case my prediction was wrong. But the monthly payment has never been higher than €700 while the rent of a similar apartment at the time was €1500: I had a pretty good margin of safety. All considered, I should not have been so greedy, taken a fixed mortgage and call it a day but I was (relatively) young and convinced I could call the bottom and only then switch from floating to fixed. I was also managing the interest rate risk on €10 billion of debt so…I was keeping my eye on the ball.
Anyway, nothing of the above really mattered because I sold the apartment after a couple of years.
The story of my UK mortgage is more amusing. It’s the second half of 2019 and I am still convinced rates can only go in one direction: down. As I said, in the UK you cannot lock any condition for the whole life of the mortgage, so anything you do is still closer to ‘floating’ than not. Why should I fix for 10 years and pay a meaningful premium over the floating option if I would not be really hedged in case rates goes bananas? I find the 5-year fixed the most bizarre of the options, I would really like to understand who choose it and why…it’s probably for lads that voted for Brexit.
So I told myself, if it has to be floating, I will go with the cheapest option, the 2-year. Little caveat on what ‘cheapest’ means: mortgages are amortized the French way, nothing sexy but a sneaky way to screw the borrower. While monthly installments are constant, in the earlier part of the loan a bigger portion of the payment goes against interest. This process is reset every time I re-negotiate the mortgage, meaning that if I re-neg every 2 years, after 6 years I would have repaid less principal of my loan compared to a scenario where I took a 6-year fixed loan. The bank is also charging a fee every time I re-neg, which increases the real cost of the shorter option.
I took an incredible, but apparently normal in the UK, amount of time to close the deal on the apartment and I signed the mortgage in March 2020, two days before the BOE cut further the official rate to 10bps: I did not pay yet and I already got a discount!
Everything went great until November 2021, when the market screamed to me that my longstanding forecast of at best muted future rate increases was bullshit. My wife was pregnant with our second child, set to deliver in May: the perfect storm was brewing in front of me, a double-up in childcare bills and mortgage payments set to delight the Bitcoin crowd, to the moon. I was not thinking that a 2% risk-free rate would have been a black swan but I would never have contemplated the possibility of getting there so fast. I called the bank, they told me I could negotiate the new iteration of my mortgage only after March 2022. So I sit tight and in March I evaluated my options:
- I could not go floating again because my 2023 budget would have exploded
- I did not want to tighten my hands for too long because pretty soon I will be able to switch part of the loan to interest-only. The 2 and 5-year rates were relatively too high anyway.
- Thanks to an apparently inverted curve, the 7-year rate was good for me at 2.26%
If I wasn’t living in the UK, I would have at least considered the option of fixing my rate until maturity and being done with this stupid game, especially now that I have a family and rates were still low. If I did not have a family (and related costs like childcare), I would have stuck with the floating rate for sure: considering “my” spread of 94bps (what I had on the first iteration of the mortgage plus the fee and amortization costs), the 7-year option would be better than floating if the BOE rate stays on average above 1.32% in the period. I would still take the under on that. Why?
Forecasting inflation
It feels weird to think that 1.32% might be too high of a level for neutral rates and my opinion is definitely warped by the scars of the last decade(s). After 2009, I thought we would never see high inflation in the ‘developed’ world (is still the UK part of it?). Before 2009, I thought it would have been likely and I got disappointed all the way.
At least now I know that forecasting inflation in the long term is a very complicated exercise. Take this podcast as evidence: four bright people, with different and opposite conclusions.
Did I take too much risk without realizing it? Was I lucky? I am 44 and I had a mortgage for a total of 5 years, is my sample simply too small?
While I was in the renegotiation process, I called a money manager friend about the 7-year 2.26% rate and he quickly replied that I was stupid to even ask the question. Maybe. It is still a big financial decision, the biggest I had to take so far. No time is too much to deliberate over it. But probably the risk/reward profile is still so skewed that I should not chase bps to risk %.
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