One year ago I signed my first mortgage in UK; in less than one year, I will have to renegotiate it. For everyone not living on the-perennial-rain island (no, not that one, the one on the right, the one with the Queen) this must sound like a shocker. 90% of the people that lives in Europe, and for sure 99% of their parents, go through the mortgage process once in their lifetime: you find the place where you are going to live, sign a multi-decade debt and that’s it. A mortgage, more than a marriage, is for life (unless you are the half that has to leave after the divorce).
“Geriatric Millennials” and younger generations would most likely adopt a more dynamic approach, buy something that is good for now (you and your partner) just to jump on the ladder, with the goal to upgrade their shelter later, when the family grows. Even in this case, the first mortgage is a relationship intended to last at least in the medium term, but most importantly a relationship that you can fix for the very long term.
In UK, this is not possible*. * = in UK you can sign a mortgage for 30 years BUT the conditions on that mortgage will change at a certain point of its life, and obviously for the worst (so worst). In Europe, but I guess in the US as well based on what I read/listen around, you have basically one choice to make: do you want a fix mortgage or a floating mortgage? If you choose fix then you are sure (yes, even if the lender defaults you will still be on the hook…small dream I had during the Great Financial Crisis) how much you will have to pay every month for the next 30 years.
In UK, the longest period you can fix is 10 years, even if you sign a 30 years obligation. For the remaining 20 years, your mortgage will be floating…with a kicker 😉 For example, my mortgage has a 89bps spread for the first two years and then the spread jumps to a very moderate 349bps spread, almost 4X! I am a prime borrower but basically every mortgage in UK is like those subprime loans that got famous during the GFC featuring a ‘teaser’ rate at the beginning and then a monster rate for most of the loan. Little I knew that what became the poster child of how not to lend money in the US is just the norm in UK. If you ask English people, this is completely normal; when I asked an Italian friend that moved here 10 years before me, his reply was a laconic “English people like to negotiate and then renegotiate and then renegotiate and and”.
No one expects you to pay the monster rate, not even the bank that is lending you the funds. From 120 or 90 days before the end of the teaser/normal interest period, you can renegotiate the terms (but if you forget…). This is more normal if you consider that in UK not even your broadband contract has a fixed price; everything is a game between you choosing an ‘offer’ and the service provider that tries to milk you in every possible way at the end of such offer…so you are pushed to find another offer and the game starts again. In an open economy where you have from 5 to 10 providers for the same service, I was wondering why no one gives you the possibility to have an ‘European contract’, something that you do not have to stay behind every 24 months. The truth is that I am in the very minority here, everyone else enjoys spending their days on the phone talking with someone with an incomprehensible accent so that they got the bargain of their life. Get a life punk.
The costs
As for everything else in life, this fun ain’t for free. There is an explicit cost, the Product fee, that you can pay at inception or add to the loan balance. If you go for the second solution, the bank typically increases also the spread it charges you: double the fun! It’s funny because if you ask them the reason of the fee, they tell you it covers admin cost; so you ask them why you do not let me borrow money at the same condition for the whole life of the mortgage, so that you can avoid this admin burden…and they tell you it is not possible.
The second fee is bigger and obviously not so explicit. Mortgages are repaid in a weird way, so weird that is technically called the French method. While the instalment amount is constant in each period, interest decreases as loan periods pass and amortized capital increases in every new period. This means that if your monthly payment is £1000, the first month you pay £500 of principal and £500 of interest while the last month your £1000 outflow is almost all principal; in other words, if you have a 30 years mortgage, after 15 years you did not pay half of the loan but less.
The trick is that every time you renegotiate, even with the same bank, the ‘new’ mortgage frontloads back all the interest, it ‘reset’ your status back to your first ratio of X principal and (1-X) interest. This means that if you put together the old and the new loans, in the end you paid more interest compared to a single, non-renegotiated mortgage. Bet you a pint that if you ask 100 English lads, 99 are not aware of this cost.
Your Mortgage is the best hedge against inflation
You best hedge against inflation is having debt. If inflation grows at 3% and today you have £100, next year your cash can buy only £97 worth of goods. As much as this works on the asset side, the cash you hold, it works as well on the liability side, if you have £100 of debt. Inflation reduces the value of your debt in the future and by definition this reduction always matches the inflation level: the higher it is, the higher the benefit for you.
If the cost of your mortgage is less than inflation, you are gaining money even if you think you are paying interest. This is the official inflation rate in Europe in the last 25 years; I let you decide how representative of the real inflation this data is, but you can see in the long term it has been quite stable around 1.5%
This means that if you can fix a mortgage at an all-in cost that is lower than 1.5% you are in a great position. Well, if you live in Europe…because as I said before, in UK you can at best fix your cost for the next 10 years, not exactly the long term you have in your mind.
Better lucky than good
Yet if you were in UK in the past 15 years, their weird logic of not giving you access to fixed long term borrowing would have greatly benefitted you.
I have participated to quite a number of bond issuances in my professional capacity in the last 15 years. If I got a pound every time someone said “rates cannot go lower than this, issuing fix debt will be a huge bargain” I would be FIRE by now. If pro cannot get it right, imagine someone that is signing his first mortgage. Not only I do not blame you for having signed a 30 years fixed mortgage, I think it was the best risk-adjusted choice: you have full visibility on your costs for the future and if you can easily afford it (or not that easily but have the prospect of increasing your revenues progressing your career) does not really matter your would have saved some thousands…just icing on a cake. There is obviously a reason why my bosses took that decision: that was the consensus (it is better to have company if you are wrong) and anyway your tenor at the job is most likely shorter than the maturity of the bond you issued, if your gamble against consensus was correct someone else would have benefitted.
The UK system put borrowers in the best situation: even if you wanted to borrow fixed for a long time, you could not; instead, you were ‘forced’ to reneg at lower and lower rates…not bad!
This time is different?
When I did my first mortgage in Luxembourg (2009?) I YOLOed thinking “fuck it, Europe is the new Japan” and went for a floating rate. I ended up holding the apartment (and related mortgage) for just two years but I made the right choice. When I signed my mortgage here, and the BOE rate was already at its all-time-low of 0.25%, again “fuck it, UK is the new Europe”. Between the day I signed and my first payment, the BOE cut its rate by further 15bps. If you do not know what Japan means, it is this:
After peaking in the early ’90, rates went in one direction: down. It became a meme because in those 30 years there has been a constant expectation that rates have bottomed and ‘next year we are going to see them rise’ but that scenario did not materialise and probably wont in my working lifetime neither.
A floating debt is normally priced cheaper compared to a fixed one at inception: 9 out of 10 times the market is pricing an upward sloping curve (future rates are higher than current ones) and the fixed rate represent an insurance for the borrower (you know today who much you are going to pay for the life of the loan), therefore the fix borrower has to pay this insurance cost. This means that the floating borrower wins in 2 out of 3 cases: if rates goes down but also if rates do not move.
Last year I spent a couple of months preparing a document to demonstrate how prepared my employer is if the BOE decides to go negative. Negative rates are such a policy failure that I am still shocked English people decided to avoid (so far), they had such a great track record lately in taking the wrongest possible choice. Never say never in life but at the moment I think rates in UK can (if they move) go only in one direction: up; the main risk to this is if a new COVID-variant emerges that is immune to the vaccines, but my contact at the Wuhan lab told me they did not achieve it yet. My judgement might also be influenced by the fact that I heard some many times the word inflation lately that I included it as a candidate for the name of my second child (I guess it works for both, boy or girl).
In short, I am ready to consider a fixed mortgage. Out of curiosity, I went to check current rates offered by my bank and, surprise surprise, not only the 7 years fixed rate is quite cheap, it is the cheapest rate offered. This is the second important element to consider when you choose your mortgage: sometimes banks price their products in a not ‘interest rates follow an upward sloping curve’ way. Spreads are higher compared to a year ago, I think due to the recent strong performance of the real estate market. The inverted price here, the 7 years has a lower spread than the 2 years, might be driven by the particular book of interest rate exposures my bank is currently holding (just going on a limb here, not an expert). This is to say that even if you have a view on the market, or a particular personal preference for a rate, you have to always consider it in the context of the prices offered to you.
In my situation, even if the BOE would indeed go negative and cut the base rate by 25bps in the next 7 years, I would still pay less choosing the 7 years fixed than the 2 years floating (assuming I would refinance after the 2 years at a similar floating spread). This is a simple example using one bank, if you decide to put them in competition using a broker you would have more choices but ultimately the decision tree will be the same.
Interest Only Mortgage
I used to consider this product only for deranged people that wanted to buy a house bigger than what they can afford…and justify the decision with “house prices always go up anyway”. Today I still hate 99% of the people that choose this product because they ruined it for everyone else. In an ideal world, the standard mortgage should be interest only…with a clause that the amount you would pay to cover the principal of the loan is instead saved in a diversified equity fund. The best feature of a mortgage is that it represent forced savings; the worst feature of a mortgage is that force you to put all your eggs in one basket, your home.
For a normal (i.e. not rich) person that decide to buy a house, that investment would represent between 50% and 80% of their assets for the majority of their life. If you assume an initial 20% down-payment and no other principal repayment, an interest rate only mortgage would allow this person to grow their portfolio not only outside real estate, but outside the specific area they live in. Here in UK you can even assign just a part of your mortgage to be IR only, like 50%. Unfortunately to access this product you have to go through so many hoops (just to remind you, in UK I was not able to have a bloody phone contract because I had no credit history on the island when I arrived), partly because if you ask for it there is a 90% chance you are a deranged person, that I am not sure I want to complicate further my life. But, it would be the right choice.
The offset mortgage
This is quite an interesting product I did not know existed. Basically you link your loan to a saving account and the balance of the saving account is used to offset the loan balance. A mortgage is the cheapest loan you will access in your life (again, if you are not rich and do not have any Amazon shares to post as collateral). Let’s assume you are one of those people that is uncomfortable living with such a big debt burden, so you decide to repay your loan faster than the normal schedule. This is a form of saving; there is only issue: one day an unexpected event happens, like you end up in the hospital and you need a relevant sum to save your life. You saved hundred of thousand of pounds but they all stuck in your home equity, to access them you have to re-sign a new mortgage from scratch, not exactly like logging into your IB account and selling some shares. The offset mortgage solves this issue: you put the money into the saving account and as long as they are there, you pay less interest (or your mortgage becomes shorter), and if you need them, you can take it with a click on your phone.
Too good to be true? Kind of. For this privilege, the spread on your mortgage is higher than a standard one. With rates so low and few ways to get access to cheap financing, for me repaying early your mortgage is a really bad financial idea (see above). If you are that type of person that think all debt is a sin and consider your peace of mind more valuable than some bps (30 to 40 in the current market), then I think this product might be for you.
What I am reading now:
Follow me on Twitter @nprotasoni