Safe as Houses?

Several times in this space, I’ve spoken of the recklessness of the 100% mortgage and how it both shouldn’t have been offered to many of the people it was sold to and how those people should have had the sense not to take it.

A mortgage is in fact a very simple instrument, but it is often portrayed as a complex and unique financial proposition (at least as far as everyday finance goes). I think this bank- and media-fueled portrayal is a key reason why many people accepted mortgages they should not have done—they were blinded by the belief a mortgage was “too complicated” for non-financially savvy people such as themselves and so shirked their responsibility to understand and evaluate the risks.

A mortgage is simply a large, secured loan. It’s nothing special, besides the size. As with a standard loan, you agree to pay back an amount of money at a given interest rate. As you are borrowing a large amount, the bank requires a guarantee that they will be able to recoup the amount you borrowed—even if you are unable to keep up your repayments. While the security is typically the same house you are buying, it’s really just a neat coincidence that the item you are using the loan for is worth about the right amount to act as a security. Most people simply don’t have other assets of equivalent value.

That last point is very important. The security means that the bank is able to take ownership of—i.e., repossess—your home in an attempt to pay back the loan. When you take out the loan, the bank is satisfied that the proceeds from selling your house will cover paying back the whole of any monies owed—either if it needs to repossess or you decide to sell the house. The bank satisfies itself by looking at the value of the property now, and predicting whether the property will hold its value into the future.

When you come to move—whether you decide to move or the bank ends up having to repossess your house—if the value of your house goes up or even stays the same, all is peaches and cream (bar the possible loss to you of your house). The proceeds of the sale will cover your mortgage and you won’t owe the bank anything. If the price of the house should decrease, however, it’s much worse: it’s possible that the sale of the house would not pay off all the money you owe the bank. Even if you keep paying your mortgage, you are effectively trapped in your house as moving will not pay off your debt. If your house is repossessed, it’s even worse: you would lose your house and still owe the bank money. This is negative equity, and why it is such a bad situation.

This is really the crux of why a 100%—or more!—mortgage is such a big gamble. You are betting very heavily on a rise in the price of your property, and you are rejecting any cushion for falls in value—which are far from uncommon.

This is why a reasonable deposit is so important¹. In addition to its typical indication to a bank of your saving prowess—and thus your ability to live within your means and pay back your mortgage—a deposit also provides cushioning should your house decrease in value. If you wanted to move, say to change jobs, you would be able to do so more easily. If your house has decreased in value, you might lose some of the money you put down as deposit if you sell it, but the amount you would raise from the sale of your house would still cover repaying your mortgage—a far preferable situation to the situation you would face under the spectre of negative equity.

This all comes down to the fact that in addition to the excitement of owning somewhere of your own, buying a house should be a move which offers more security than renting, providing a home base to launch from. It should offer a sense of place and a calm space to escape the outside world when needed. A 100% mortgage will always significantly reduce any security your home offers as you will be held in sway to every movement of the housing market, which is a recipe for obsession and stress.

And that, in short, is why I think that all parties involved in the 100% mortgage bubble were reckless, short-sighted and just plain foolhardy.

¹ What do I think is reasonable? Around 10% at a minimum, but I’d still feel a little wary anywhere below 20% in the current market.