How have house prices risen so much?

This is a crucial piece of understanding which can be broken down into three key components:-


1. Above Average Earners Buy Below Average Properties

Even when the average house is unaffordable to the average home buyer, it is not unaffordable to people on above average earnings. Recently these buyers have accepted smaller properties than they would normally expect in order to get onto the housing ladder. So as house prices rise we have big earners choosing to live in progressively smaller houses. They have prioritised the desire to own their own house above their quality of life. This is why tiny flats, in poor locations have been fetching high prices.

Lets compare a two sets of homebuyers in December 2006. Each person in “Couple 1” earns the national average salary while each person in “Couple 2” earns double the average salary.


                                                                            Couple 1          Couple 2
Median salary                                                       £23,600             £47,200
Average House Price                                           £207,573            £207,573
Mortgage available at 2.5 X joint salary:             £118,000            £236,000
Additional deposit required                                  £89,573               None


It can be seen that the average property is certainly affordable to “Couple 2”, but significantly out of reach of “Couple 1”. In normal market conditions the higher earning “Couple 2” would traditionally have purchased a detached house with a spacious garden in great location. Forced to lower their expectations by the rise in house prices these buyers might instead purchase a 2 bedroom flat or small terraced house in a sub-prime location.

Thus, as long as above average earners are willing to compromise and accept smaller properties, money will continue to flow into the market and push house prices higher. The question is therefore raised “How much further are these buyers willing to compromise to buy a home of their own?” Studio flats? Box rooms? There is a limit to their desires to own, and once this limit is reached it becomes increasingly unlikely that house prices will rise much further.


2. Buyers Switch to Interest Only Mortgages

Buyers have traditionally favoured “repayment” mortgages in which the loan is paid back over the life of the mortgage such that the buyer owns the whole property by the end the mortgage term. Lately there has been a shift towards “interest only” mortgages in which the loan balance remains the same over the mortgage term and only the interest is on the loan is paid off by the buyer. At the end of the mortgage the buyer must then pay back the entire amount borrowed. For example:


                                                           Repayment          Interest Only
Size of Mortgage taken out                   £200,000               £200,000
Mortgage details                               25 years at 6%       25 years at 6%
Monthly payment                                    £1,289                   £1,000
Amount owed after 25 years                      £0                     £200,000


For the interest only mortgage, at the end of the 25 years the buyer must either sell the house to pay back the loan, or as is more usually the case, they will have paid into an investment vehicle over the 25 year period in the hope that the value of their investment can pay back the loan amount. By all accounts, this is a much riskier approach.

The reason that interest only mortgages have become more popular is simply that the monthly payments are lower than those of the equivalent repayment mortgage. Assuming a buyer has no deposit and a monthly mortgage budget of £1,289 he can borrow £200,000 under a repayment mortgage to buy a house worth that same £200,000. Alternatively, for the same monthly payment he can take out a larger interest only mortgage of £258,000 and buy a £258,000 house.

This is not a wise approach however! The buyer is not supposed to use the difference between the two monthly payment options to borrow more and buy a bigger house. The buyer is supposed to invest the difference in an investment vehicle in order to pay off the final loan.

In this situation, buyers have traded the security of a repayment mortgage for the ability to buy a more expensive house with a higher level of debt, and combined it with a lower chance of paying off the final loan. As the number of buyers taking this approach has increased, they have borrowed more to fund their purchases, and this has helped to support rising house prices.


3. Banks Switch Their Focus to Affordability Across All Loan Types

The banks also play their part in pushing house prices higher. If they adhered to their traditional lending multiples they would have been forced to stop lending to the vast majority of homebuyers long ago. However, as a result of the huge surge in global money supply, banks have found themselves awash with money. In order to generate a return on their available funds, the banks have sought to lend out as much as possible by gradually relaxing their lending criteria. One way in which they do this is by moving away from using standard salary multiples and using affordability as a gauge of borrowing ability instead.

For example, in December 2006 the average couple can obtain a mortgage of £118,000 (median salary of £23,600 x 2 people x 2.5 mortgage multiple). For a 25 year mortgage at 6%, the monthly repayments are £760. Keen to obtain the maximum mortgage possible the couple may be able to demonstrate they can actually afford to pay more, say £1,100 per month, which equates to a larger mortgage of £170,000.

In effect the bank is willing to lend the buyers an additional £52,000. It has indirectly increased the multiples of salary it is willing to lend. The £170,000 mortgage is 3.6 times joint salary (£170,000 / (£23,600 x 2)), significantly higher than the traditional and time-tested 2.5 x limit. And because the buyers can now borrow more, the deposit they require is more manageable allowing them to buy a more expensive house.


Conclusion

House prices have continued to rise for two main reasons. The first reason relates to the compromise buyers are willing to make between owning a building and their quality of life. Recently buyers have chosen to buy and live in smaller, sub-prime properties. There is a limit to the size of the compromise however. The second reason relates to an acceptance of significantly higher levels of debt. Whether selecting an interest only mortgage over a repayment one, or attempting to borrow more by demonstrating a higher level of affordability, buyers have propped up house prices by assuming vast amounts of debt. Once this precarious position begins to unwind itself, many buyers will find themselves dangerously exposed to falling house prices.