Discussions about how to join the property market, happen fairly frequently in my life. A lot of my peers have got their eyes fixated on buying property as a first investment. They dream about getting onto the “housing ladder” by taking out a big mortgage. I usually take the sparsely populated angle that housing is probably the worst first investment one can ever make (unless you’ve got a few hundred thousands quid/bucks/euros sitting around in your bank account).
Amongst the pro arguments I’ve heard, the following make frequent appearances: “renting is like throwing away money” (the actual vocab is somewhat more vulgar) or “the longer I wait, the more expensive it will get”. Everyone in the UK (where I currently live) is obsessed with owning their own home and wanting to switch their monthly rent checks with monthly interest payments.
But seriously, is it really a good idea to have your first investment be a house?
Obviously the answer to this is different for each individual, and I’m not by any means trying to dish out advice. Everyone should do their own research and figure out for themselves whether they want to buy a place. The answer will depend on your own financial situation, whether you are single/have a partner to share with and what your immediate and longer term career ambitions are etc etc.
Since the financial state is the easiest to compare and analyse, let’s see what your financial situation is. Have you got enough money to afford a deposit on a house? If so what percentage of the total house price can you put down?
Now before I kick off, I’d like to highlight that probably 90% of the people I talk to consider themselves quite knowledgeable about the housing market (myself included!): everyone has at one point lived in a house, everyone knows the advantages and disadvantages of local areas, and the old saying that property can only ever go up sounds better the more you say it (try it!). After all, rich foreigners are buying London up. I find the last one quite hilarious because it is repeated so often that it can only be right! I mean, who cares about the time when the Scandinavian housing market blew up in the early 1990s. Or the more recent 2007/08 subprime crisis in the US pulling all property valuations lower. Also who cares that interest rates and housing markets are inversely correlated (when interest rates go up, housing goes down). And that interest rates at the moment are at record lows and have been here for the past 6 years. Doesn’t really matter riiiiight?
Let’s ignore the market for now and look at individual scenarios:
Joe has 20,000 in his bank account that he’s willing to put as a deposit for a house. The 2 bedroom house he’s looking at costs 200,000 and he’s very keen on buying it. The bank he talks to offers to stake him out with the remaining 180,000 (at 4% interest) he needs in order to buy the house (ie a 90% mortgage). He buys his dream house and makes his monthly payment of roughly 860 over the next 30years.
At this point it is worth taking a closer look at his mortgage. His monthly payments stack up to 10,320 each year, making a total of 309,600 over the next 30years. As you will have noted, this far exceeds the 180,000 principal of his mortgage. The difference (129,600) is the interest that Joe pays over the 30year tenor. At the start of his mortgage agreement, Joe will be paying 600 in interest with an additional 260 that will pay off his principal. Each month the interest figure will decline whilst the principal payment will increase marginally. In the last few instalments Joe will be paying less and less in interest and will be paying more and more towards getting his principal lower. But this is only if the mortgage rate stay at 4%.
The chart will look something like this.
So let’s assume that over the course of 30years, the mortgage rate goes up by 1% 5 years in. Joe’s position will look somewhat different:
5 years from today, Joe has paid off 34,350 in interest and 17,200 in principal and has an outstanding interest bill of 95,000 as well as 163,000 in outstanding principal. He has also nearly paid 10% of his principal but his outstanding interest bill is still over half of the principal. If he hasn’t got much disposable income (i.e. spending money), he will be in trouble meeting his increased monthly mortgage payments.
As a comparison, Emma is looking to buy a house too in Scenario #2.
She has saved up 100,000. Emma finds a decent house which costs 200,000 and she also has a willing lender who will put up the 100,000 to cover the shortfall. Her monthly payments total roughly 480 and compose of 335 worth of interest payments compared to 145 worth of principal repayments at the start of her mortgage. Over the course of the 30year mortgage that adds up to 172,800 in payments which is 72,800 over the principal amount, thereby constituting the balance of interest payments.
5 years from today, Emma has paid 29,100 in interest and 9550 in principal. And has 52,800 in interest payments outstanding and owes 90,450 in principal. Since mortgage rates have gone up to 5% from 4%, her new monthly payment will be somewhat higher given the higher interest payments she has to make on the outstanding principal. But she has already paid off 10% of her principal and she can easily swallow the increased cost of the monthly payments because the overall burden is much lower.
I’ll try and dig up some mortgage to income ratios. In the London area this ratio is at insane levels, meaning that any moderate interest rate rise will cause a lot of borrowers to be in trouble. But don’t believe it til I post veritable facts here.
In the above scenarios I want to highlight one thing:
-The huge cost that the interest payments make up… in some cases more than to the principal itself. Joe’s interest payments are 72% of his principal amount! In essence you’re buying the house at more than 65% of it’s current value. Emma’s is much ‘better’ at only 36.4% higher than the market value of the house.
Essentially taking out a mortgage is a bet on the housing market to advance, as it only really makes sense if the house you purchase surpasses the breakeven point of the initial value of your house + the interest paid from the mortgage.
Moreover, one is also betting that interest rates will stay steady or go down. The lesson I’m trying to draw is that the larger the loan, the more you need things to go your way, whether it is the housing market going up or interest rates staying low.
We haven’t even touched the upfront costs (lawyer fees, surveyors fees, stamp duty, mortgage broker fees, real estate broker fees). In the UK, stamp duty alone can cost 5% of the purchase price (if the property is valued at between £250,000-925,000, that is £12,500- 46,250 for the aforementioned range). So when you come to sell your home, don’t forget all the money you spent on it before you setting even one foot in it.
Finally, I’d just like to touch on the dreaded alternative to buying…. renting!
Have a look at the above costs for buying a place, adding in the interest you will be paying over the course of your mortgage(d) lifetime and try and calculate when at your current rent, you would surpass that breakeven point. Often you’ll be financially better off renting and waiting for your deposit money to grow than investing in a property with a huge mortgage.
A paper published by a duo working for the Federal Reserve as well as University Of Warwick examined whether high levels of home ownership impede a flexible labour market. Though they could only speculate on why this would the case, they found a clear correlation between high levels of home ownership and higher unemployment, listing various potential reasons. For example they saw home owners take on longer commutes due to them being unwilling or unable to move/sell their houses resulting in higher costs for employee and employer and decreased productivity.
Their study was based on the US but they used countries such as Switzerland (30% of population are owners, 3% unemployment) and Spain (80% of population are owners, 20% unemployment). Nothing conclusive and more study is needed, but interesting comparisons nonetheless. You could be doing your career a favour if you don’t get on the property ladder just yet. Who knows how many excellent job offers you’ll have to turn down because of your purchase.
Renting can be a great alternative to stomping up huge costs and taking out a mortgage that’s too big for you to shoulder if things turn to the worse. The cash you save, can be invested elsewhere in the meantime and in assets that can actually give you a tangible and liquid return such as public and private companies or bonds.
Anyhow, this post is already long enough. Hope you liked my ramble and saw the benefits in keeping the mortgage small or renting and investing elsewhere before you invest in a house.