I’m fortunate enough to only have two debts. One is a hefty and never-diminishing sleep debt. I pay it back when I can but, much like an interest-only mortgage, the principle seems to never decrease. The second is a mortgage. Oxymoronic ‘good debt’.
As of 1st August, the Bank of England will withdraw its affordability test recommendation to mortgage lenders. The test “specifies a stress interest rate for lenders when assessing prospective borrowers’ ability to repay a mortgage“. My own mortgage has already been through that mill once.
At the same time, interest rates have climbed to their highest level in over a decade. Inspired by these events and a recent Monevator post, I did some stress testing of the MedFI household mortgage finance.
When my fixed rate ends, I’ll have to re-mortgage. The key factors determining how much the new mortgage will cost are:
1. The value of my property.
2. Loan-to-value ratio: the amount of money I’ll need to borrow from a bank compared to the total value of the house.
3. Mortgage interest rates.
My crystal ball has gone on the blink, so I’ve done my best to make sensible estimates of each of these below.
Housing market crash
Are a fall in house prices a matter of when, not if? One putative, albeit far from cast-iron, predictor of property prices is Fred Harrison’s 18yr property cycle theory.
Exploring the (de)merits of Harrison’s theory is beyond the purview of this post; in short he predicts the next UK property crash will occur in 2026. Some are forecasting a slowing down of house price increases as early as 2023. Conversely, the chaps over at Property Hub have postulated the crash will occur later (as late as 2029), on account of:
• Double-digit growth only recently started; 2021 was the first year since 2008 where the average UK property price grew >10%
• Lending restraint still fairly established, although the Bank of England did withdraw their affordability test as above
• Investor sentiment hasn’t reached the mania indicative of a near-peaking market
I think Harrison’s theory is of debatable absolute predictability, comes with a fair dose of confirmation bias and, ultimately, simply demonstrates the fact that property prices are cyclical.
However, in the absence of a better model, let’s say there’ll be a property market crash at the time I have to re-mortgage. To model what a housing market crash could mean for me, I used data from the most recent one – the 2008 Global Financial Crisis.
There are a few different numbers from the GFC I could use when estimating how far my property price might fall:
• -15.6%. The worst year-on-year decrease in UK average house price (February 2009).
• -18.5%. The nadir average UK house price (March 2009, £154k) vs. it’s pre-crash peak (September 2007, £190k).
• -11.5%. Presuming a crash occurs in 2026, this is the fall in house price at the time I’d have to re-mortgage.
In the end, with nothing better springing to mind, I used an average of those three figures (15%) in my stress test calculations.
The 18yr theory would suggest the crash/recovery phase takes four years. During the GFC, annual house price change remained negative for nineteen months (May 2008 – November 2009). Despite that, it took nearly seven years for the average UK house price to return to the same pre-crash price (October 2007 – July 2014)!
A falling home value at the time I had to re-mortgage would be punitive. Much like other assets, however, the actual loss in value would only be crystallised if we were forced to sell the house.
Yes, a dipping housing market would be certainly sub-optimal. Worse still would be negative equity, whereby the value of my house would be less than the outstanding money owed on the mortgage. Fortunately, there would have to be a precipitous (37%) drop in the property’s value for us to end up in that sort of territory. It’s not an unheard of fall, but at the less likely end of the spectrum in my opinion.
Housing market swell
Conversely, my house could increase in value by the time of re-mortgaging. I could use a few different numbers to estimate the increase in my home’s value. As before, I took the average (11%) of a spectrum of price increases for my stress tests.
My LTV will be dependent on the value of my property (see above) and the remaining loan at the time I re-mortgage.
Fortunately, the amount I’d still owe is quite predictable. Using an amortisation table, I can calculate the outstanding debt at the time of re-mortgaging. Furthermore, I can see how much overpaying the mortgage affects this.
For my stress test I used two scenarios; one paying the mortgage as is, and the other overpaying the mortgage by a set amount each month.
Mortgage interest rates
Future mortgage interest rates are difficult to divine. They’re based on a whole host of economic factors. Interest rates are on the rise though, and it’s a fair presumption that any future mortgage interest rates are going to be higher than my existing rate.
For my stress testing, I used a few different interest rates: the current available rate (2.5 – 3%), twenty-five year average (~5%) or twenty-five year high (~8%).
Stress testing a re-mortgage
In summary, some presumptions I made for modelling a re-mortgage:
1. My house’s value will be either: higher (+11%), the same as purchase price or, if it coincides with a market crash, lower (-15%)
2. Outstanding mortgage as per amortisation calculations, including an overpayment scenario
3. The mortgage interest rate will be either of the three rates described above (2.75%, 5% or 8%)
The results made for less-than-pleasant reading.
The best case scenario involved overpaying the mortgage and a future interest rate similar to the best available today (2.75%). In that case, mortgage payments would be ‘only’ 13% higher than they are currently. Without overpayments, I estimate they’ll be 20% higher.
At 5% interest rates, I estimate mortgage payments will be 50% (overpay mortgage) to 59% (no overpayment) higher.
At 8% interest rates, mortgage payments will be >100% higher than currently, whether I overpay the mortgage or not.
Mortgage interest cover
A litmus test of my resilience against these rising mortgage costs is my personal home interest coverage ratio.
I ran the numbers as described above by The Escape Artist, though using ‘post-tax salary’ as the numerator doesn’t make sense to me. If mortgage payments rose dramatically we’d cut back on our spending, though the reality is that we couldn’t use our entire post-tax salary to pay the mortgage. There are other bills to pay, hungry mouths to feed and various other essential living expenses.
I decided there was a more pragmatic method for calculating our interest coverage ratio.
Mortgage cover = (current mortgage payment + discretionary expenses) / future mortgage payment
This method presumes you’re already able to afford your current mortgage payments. When the cost of the mortgage goes up, where does the extra money come from? Cutting back on the discretionary expenses would typically be the first line of defence.
On my expenditure spreadsheet, discretionary expenses represent purchases such as eating/drinking out, entertainment (Netflix, new kit for sporting hobbies etc.) and holidays. Reducing this outlay might provide enough capital to make the pricier future mortgage payments. Meanwhile, essential expenses such as bills, groceries, healthcare etc. are left untouched.
I used this method in my own calculations. Reassuringly, our mortgage interest coverage ratio never dips below 1x, even when ‘stressed’ with an 8% interest rate, -15% house value and no mortgage overpayment. Of course those numbers are dependent on a key factor: unchanging income.
There are a spectrum of income shocks I could suffer that would impact on my ability to pay the mortgage.
At the ‘tamest’ end of the spectrum, my salary continues to be eroded by inflation. At the time of writing, UK inflation is 8%/yr, quadruple the annual pay rise for junior doctors (2% until April 2023). This equates to a net 6%/yr pay cut, on top of decades of inflation-eroded pay.
My income could falter because of changes to my work circumstances. Those range from opting to work less-than-full-time, to being booted off my postgraduate specialist training programme, to being struck off the list of registered medical practitioners altogether.
At the more macabre end of the spectrum, perhaps I’d suffer a critical illness (or even a life-ending event) that’d strip me of my ability to earn an income.
A more likely scenario is a drop in household income on account of maternity leave/pay and a subsequent increase in (essential) child-care expenditure.
Much to do about something
What can I do to mitigate against this all? Some thoughts:
• House prices. I’m essentially at the mercy of the markets, bar any normal interventions to keep the property ticking over
• LTV ratio: overpay the mortgage. Or invest?! A story for another time.
• Mortgage interest rates. I’ve no control over the BoE so not much luck here. I could re-mortgage early with a longer fixed term to try and lock in a lower rate if I felt there were worse rises to come.
• Mortgage interest cover. I could decrease discretionary spending in anticipation of re-mortgaging?
• Income shocks. Ensuring I don’t get fired is up there. Critical illness cover and life insurance too. Earning some extra income would be nice…
Ready the lifeboats
There’s a concise summary to all of the above: my mortgage is going to be more expensive in the future. Exactly how much dearer is anybody’s guess. Despite this, I can’t envisage the mortgage becoming entirely unaffordable.
Of course, there’s always the possibility of the perfect storm. A GFC-level drop in house prices + all-time high mortgage interest rates + continued cost of living rises + a concurrent stock market dive + losing my job.
Yet I think of myself as more of a pragmatist/realist than a nihilist, and suspect there’s enough wind in the sails of HMS MedFI to weather the choppy waters on the horizon.
I’ll make sure the lifeboats are prepped though, just in case.