Monday, 9 March 2009

Economic Myth Of The Week: Mortgage interest rates are at an all time low

Here's a simpler example of the difference between average and marginal interest rates as they apply to government borrowing.

Let's imagine that three potential first time buyers are each buying a property costing £100,000 (we can ignore likely future falls in capital value here; as people who buy in this market are clearly doing). They have deposits of £40,000; £25,000 and £10,000 respectively and accept mortgage offers as follows:

First buyer: 40% deposit - interest rate 3%
Second buyer: 25% deposit - interest rate 4%
Third buyer: 10% deposit - interest rate 6%

The first buyer clearly pays 3% interest of £1,800 per annum.

The second buyer thinks he's paying 4% on his loan (£75,000 x 4% = £3,000), but actually he's not. He's paying 3% on the first £60,000 of the loan and a marginal interest rate of 8% on the next £15,000. i.e. £60,000 x 3% = £1,800 plus £15,000 x 8% = £1,200; £1,800 + £1,200 = £3,000.

The third buyer thinks he's paying 6% on his loan (£90,000 x 6% = £5,400) but he's not. He's paying a mish-mash of 3% and 8% on the first £75,000 (see second buyer), but the bank is actually charging him a marginal interest rate of 16% on the top slice of £15,000 that needs to bring him up from 75% LTV to 90% LTV, i.e. £75,000 x average 4% = £3,000, £15,000 x 16% = £2,400; £3,000 + £2,400 = £5,400.

That is the fundamental difference between average and marginal interest rates; and it is the marginal interest rates that are important.

So from the banks' point of view, it might still make sense to grant mortgages with 90% LTV; assuming funding costs of 2%, they are making an 14% markup on that last £15,000 of the loan; if banks assume that house prices fall another twenty per cent, they might end up with a loan that is legally secured but unsecured in economic terms, but at least they are making an 14% gross profit of £2,100 per annum. The bank just has to gamble on enough mugs hanging on and continuing to pay the 16% marginal rate for long enough to cancel out all the other loans that go bad and on which there is little or no recovery. Assuming a third of loans go bad in the next five years, that's an average loss of £5,000 (£15,000 x 1/3), but the other two thirds will have earned ther lender an average of £7,000 in extra interest (£15,000 x 14% x 5 years x 2/3).


neil craig said...

Also during much of the 1970s interest rates were as much as 6-8% but inflation was 10-15% so there was a real interest rate of about -5%.

Unknown said...

I hope it will keep lower for a while because I need to refinance for my home point mortgage and it must be done in a few months

Anonymous said...

Great post, Mark. Sheds a lot of light on how banks manage to make profits even with quite high default rates.

By the way, you also didn't factor in the high "arrangement fees" that they typically charge for high LTV mortgages.