Investment: The real price of mortgages

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The Independent Online
THIS IS getting serious. As if life wasn't exciting enough already, for the second time this year this column proposes to take as its theme a report from the Institute of Actuaries. The sign of a mid-life crisis? Maybe - but also a case of credit where credit is due.

The report, by the institute's working party on endowment mortgages, seems to me to have some important and interesting messages for anyone who is concerned about the mortgage market (as most of us are).

The working party set out to devise an analytical framework for deciding when an endowment mortgage might be the best choice for borrowers. This is actually not such an easy piece of analysis to do, partly because it is inherently complex, and partly because the key inputs to the equation are unknown future projections - what is going to happen to interest rates, investment returns, inflation and so on.

This may be one reason why, as the Institute correctly points out, nobody really seems to have done the exercise before, at least in public. You are certainly entitled to wonder whether that smooth talking financial adviser of yours, who so forcefully extolled the merits of an endowment policy to you, had really gone through all the calculations in the way the Institute prescribes. Fortunately, the working party's conclusions are straightforward and (in my view) bang on. The argument that they put forward runs as follows:

t Future investment returns in a low inflation world are not going to be as high as they have been in the last 25 years. This changes the nature of the calculations you need to make about the best form of mortgage. The flip side to this perspective is that mortgage rates ought also to be lower in future.

t Repayment mortgages should be the first starting point for any home loan and the benchmark against which alternatives should be judged. Mortgages are, ultimately, a specialist form of loan; and as a borrower, your first priority is to make sure that you will be able to pay back the loan at the end of the appointed term. Repayment mortgages are the only certain way of ensuring that you can do this.

This does not mean that endowment policies cannot be justified. They can be a better bet, but only if several key criteria are met. In the working party's view, this means they must be reasonably priced, they must adopt plausible return assumptions and (most importantly) borrowers should be clear about the risks that are involved.

Many current endowment mortgages are either too expensive or too inflexible to be the optimal choice in current market conditions. This is particularly true of 10 and 15-year endowments, where the cost and charging structure adopted by lenders (typically the equivalent of 1.5 per cent and 2 per cent a year) outweigh the potential returns from the investment scheme.

The bottom line is that longer- term endowments (with 20 and 25-year terms) can still make sense, provided that they come from a reasonably low-cost provider, and provided that borrowers are also willing to take on the risk of a shortfall in the investment fund should investment returns undershoot expectations. (There is also, of course, a chance that the returns on the endowment policy will eventually exceed the amount borrowed, even after costs).

One reason why endowments can still make sense on a long-term view, according to the working party, is the surprising fact that the life insurance cover which is included as part of the endowment mortgage package is often better value than the term assurance you can get if you opt for a repayment mortgage and take out your own life cover instead. Over time this can make a substantial difference in the borrower's favour, particularly if your mortgage is a large one.

Of course, it is perfectly legitimate to take issue with some of the assumptions in the working party's calculations. The main assumptions are set out in the table, where I also show how they compare with experience over the last 10 and 80 years. The great merit of the working party's approach is that it attempts to make sure that the assumptions are consistent one with another, which means linking in the mortgage rate assumption with the investment returns you are projecting. Both in turn have to be related consistently to interest rates. (Many advisers, I suspect, work with apples and pears in this respect).

It may strike you as odd that the actuaries have taken as their central projection a mortgage rate of 5.25 per cent. This rate, the actuaries believe, is the one which is consistent with their central projection of a 7 per cent future investment return, based on an endowment fund that is invested 80 per cent in shares and 20 per cent in bonds. The figure is derived by putting the mortgage rate in its proper context, which they say is a quarter to a half per cent above the yield on gilts and 2 per cent to 3 per cent above the rate of inflation.

With the typical average mortgage rate today at 6.85 per cent, 5.25 per cent may seem an heroic assumption. I don't think it is unreasonable, especially since at the moment long-term interest rates are actually lower than the short term rates on which mortgage rates are mostly based.

But the figures do highlight how expensive mortgages are in this country: on average borrowers consistently pay between 5 per cent and 6 per cent in real terms for their loans, a figure that has only barely been dented by the recent outbreak of competition in this country. The positive general conclusion that I draw from these figures is one that the actuaries do not in fact spell out, though it is implicit in their figures. This is that, whichever way you look at the numbers, mortgages on average are still too expensive in this country, and must one day come down.

It may well be that this effect is actually more important than any difference between the type of mortgage you take out. To be honest, though there has undoubtedly been some mis-selling, I am not convinced that mortgage lenders deserve all the flack they have had over endowment mortgages. There is nothing wrong with the basic product, even though it is clear that in many recent cases it has been sold too aggressively, and plainly also in many cases to people who would in retrospect have been better off with a repayment mortgage.

Just because the world has turned out differently from the way it was expected does not establish that there has been mis-selling. If mortgages come to be regulated, as now looks likely, only the most naive will believe that this will solve all the abuses which have taken place in the mortgage market. The danger with statutory regulation is that it will push up the costs of mortgages and stifle competition when the aim should be to achieve exactly the opposite.

The sooner we can move to a transparent system where long term no-strings mortgages are offered at long-term interest rates with a sensible (but not excessive) profit margin to the lender, the better off we will all be. But that day is still some way away.