Mortgages  

Should first-time buyers be offered long-term fixed rates?

  • Describe some of the problems of first time buyers getting onto the property ladder
  • Identify who the housing market is geared towards
  • Explain why long-term fixed rate mortgages might be the answer
CPD
Approx.30min
 Pexels/Ketut Subiyanto

Between 1991 and 2016, the proportion of 25-to-39-year-olds owning their home almost halved, from 67 per cent to 38 per cent; the collapse among 18-to-24-year-olds was even greater, from 36 per cent to just ten percent.

The foundation of the British economic settlement – homeownership – has by now been denied to several generations of Britons. Mrs Thatcher talked of creating a property-owning democracy: in fact, 20 of 27 European countries have a higher homeownership rate than the United Kingdom.

In part, we have failed to build enough homes: the more that are built, the lower their price will be. 

>The prudential policies necessary in a mortgage market dominated by banks lending from short funding tilt purchasing power away from first-time buyers, and so towards buy-to-let landlords

But what matters for ownership as much as how many are built is who is buying them: that point was made by ‘Resentful Renters’, a Centre for Policy Studies paper authored by Graham Edwards, and from which the government’s recently announced ‘Generation Buy’ mortgage market policy has been derived.

Home ownership

Between 2005 and 2015 the housing stock grew by 1.7m, but the number of owner-occupied homes fell by 0.4m, as the number of landlord-owned houses rose by 2.1m. If the owner-occupation rate across all age groups to 65 had been in 2016 what it was in 2005, there would be 3.57m more homeowners – these are the paper’s ‘resentful renters’. 

The rate of homeownership is lower in London and the south east where supply shortages are most acute and prices and price-to-income ratios are highest.

Curiously, though, the decline in the rate of ownership over the decade, and therefore the proportion of houses occupied by resentful renters, is geographically evenly spread. The English average is 5.6 per cent, and indeed the proportion in London is 5.8 per cent, but it is higher in Yorkshire and the Midlands at just over 6 per cent. 

The CPS paper argues that the prudential policies necessary in a mortgage market dominated by banks lending from short funding on variable rates in a low interest rate environment, as since the financial crisis, tilt purchasing power away from first-time buyers, and so towards buy-to-let landlords.

Finance for young, would-be homeowners has become scarce, whereas older households, who have accumulated wealth through historical housing inflation and generous occupational pensions, are leveraging their wealth using cheap buy-to-let finance and buying up the housing stock.

Since the failure of the US mortgage market, regulators and bankers have attempted to ensure that mortgagees can meet their repayments in the event of a spike in interest rates, and further attempted to limit the number of homeowners that would be underwater in the event of a given price fall. 

Bank of England regulations require mortgage applicants to pass an affordability test that determines whether they could make their repayments at three percentage points above their reversion rate.

So while the average interest rate actually charged to first-time buyers at the time of publication was 2.35 per cent, the average ‘stressed’ interest rate used in the test was 7.26 per cent.

In 2018 the average first-time buyer’s mortgage payment was £633 per calendar month: the affordability test would have determined that they could make repayments at £1,075 per calendar month. The CPS estimates that 2.8m renting households could make the former, but only 1m the latter.

The interest-rate stress-test does not need to be applied to mortgages with initial terms of five years or more, but most banks choose to apply it anyway. 

International regulations out of Basel now require more capital to be held against high loan-to-value (LTV) mortgages.

First-time buyers

The median first-time buyer was made a 95 per cent mortgage between 1985 and 1997, then a 90 per cent mortgage until the financial crisis, whereafter the median LTV fell to 75 per cent as market conditions tightened, and had only made it back to 85 per cent by 2017 (prior to the Covid-19 tightening there were 95 per cent mortgages on the market, but they were scarce). 

As LTVs have fallen, saving for a deposit has become harder. During the 1990s the median first-time buyer paid a deposit equivalent to about 10 per cent of their income, then in the 2000s it was between 20 per cent and 40 per cent: after the financial crisis it jumped and was still as high as 60 per cent by 2017.

CPS analysis found that this post-crisis growth in the deposit burden has occurred principally as a result of lower LTVs rather than rising house prices: 10 per cent of the median first-time buyer’s house price has been equivalent to 40 per cent of their income over the years since, as it was on the eve of the crisis.

CPS analysis shows that 3.5m of the 4.8m English private renters have incomes higher than the bottom 10 per cent of actual first-time buyers, but savings amongst tenants fall far short of deposit requirements.

Even when deposits can be acquired, loan sizes, necessarily limited due to the interest-rate risk, except for those on the highest incomes, are too small to buy anything. The result is that mortgage lending is limited to high-wealth, high-income individuals: in the decade from 2005 there 2.2m fewer first-time mortgages made than in the previous two decades.

In today’s mortgage market, then, regulators and bankers are only able to improve financial stability at the expense of home ownership.

The settlement may be financially stable but it is politically unstable: younger generations will not be content to be the eternal tenants of a new gentry.

Fixed rate mortgages

The CPS proposes an alternative, one that should both satisfy the financial stability demands of the last crisis and allow for an expansion of homeownership: first-time buyers should be offered 25-year fixed-rate mortgages, so that there is no need to stress-test them at higher rates, since they will never pay them. These mortgages should be made at 95 per cent LTV.

In 2018 the average first-time buyer bought a house for £182,700, so we use that price in the following example. At 95 per cent LTV the mortgage would be £173,600, and the stressed payment hurdle would be £1,219, which only 0.65m renting households could jump.

The CPS estimates that a 25-year fix with an early repayment charge in the first five years could be made at an interest rate of 3.7 per cent, and so monthly repayments of £888, which could be afforded by 1.7m households, that is, 1.05m more. The CPS also models a ‘step-up’ mortgage, in which repayments are increased by 2 per cent per year to keep them roughly constant in real terms: in this case the initial monthly payment is £672, which could be afforded by 2. m households, that is, 1.85m more.

These long-term mortgages should be made by institutional investors with access to long-term funding, and which do not bear the risk that their funding costs will one day exceed their lending rate as a bank would.

Banks rely on short-term funding: more than 80 per cent of both Barclays’ and RBS’ funding is repayable within three months. Pension funds and insurance firms would be more natural providers of these mortgages: Barclays’ pension fund is 80 per cent payable over more than ten years and Aviva’s is a third payable over more than 15 years. Denmark’s mortgage market currently operates similarly to the one proposed here.

A mortgage market dominated by owner-occupiers on fixed-rate mortgages made by maturity-matched lenders invulnerable to a run ought to be significantly more stable than one dominated by buy-to-let landlords on variable-rate mortgages made by maturity-mismatched lenders vulnerable to a run.

Negative equity

Of course, 95 per cent mortgagees are more vulnerable to negative equity than those with lower LTVs, but it is really the combination of repayment difficulties and negative equity that threatens financial stability, and that combination is most likely to be brought about by rising interest rates, to which fixed-rate mortgagees are invulnerable.

It is right to be concerned about negative equity in an overpriced housing market. Pre-eminent macro-finance economists Atif Mian and Amir Sufi in their book ‘House of Debt’ recommend equity-like mortgages in which the mortgage principal and monthly payments fall with the house price; the lender is compensated for providing this downside protection by taking a small proportion of any capital gain on sale. This solution, for example, more comprehensively deals with the negative equity threat, and does so in a way that promotes rather than hinders homeownership.

Should the mortgages proposed by the CPS successfully improve access to housing finance for today’s resentful renters, they will put upward pressure on house prices while supply is inelastic. So making supply more elastic by reforming the planning system, and building more new homes, must be a parallel objective. 

The relationship between the availability of mortgage credit and house prices has not been acknowledged in mortgage policy until now, so to oppose this policy and restrict mortgage credit to lower-income, lower-wealth households on those grounds, even though an affordable and safe way for them to borrow has been proposed, would be somewhat arbitrary.

If we are to constrain mortgage credit because it is inflationary, then the manner in which it is constrained will have enormous implications for homeownership: it might instead be artificially constrained in the buy-to-let market, for instance. For consistency, the entirety of our mortgage market policy would need to be re-evaluated on that basis. 

As currently our mortgage market is dominated by banks with short funding, it is dominated by variable-rate financing.

Under these conditions, it is necessary to ensure that mortgagees can handle a spike in interest rates.

Lenders with long funding can offer fixed-rate financing at low interest rates, and so open up the mortgage market to lower-income, lower-wealth households without threatening financial stability. The move would democratise the benefits of cheap, long-term debt, currently enjoyed by landlords but kept scarce among would-be homeowners.

Conor Walsh is a researcher at the Centre for Policy Studies

CPD
Approx.30min

Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

  1. According to the author, what is the main reason for high house prices?

  2. London has far more 'resentful renters' than the rest of the UK, true or false?

  3. Who has the biggest purchasing power?

  4. What is one of the unintended consequences of stress-testing on home loans, follwing the financial crisis?

  5. Why does the author suggest a 25 year fixed rate home loan for first-time buyers?

  6. Why should long-term fixed rates be made by institutions, rather than banks?

Nearly There…

You have successfully answered all the questions correctly, well done!

You should now know…

  • Describe some of the problems of first time buyers getting onto the property ladder
  • Identify who the housing market is geared towards
  • Explain why long-term fixed rate mortgages might be the answer

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