Income Multiples

Britain's second biggest lender hit the headlines recently by offering borrowers up to 5x their salary, a marked increase on the generally accepted rate of between 3 and 3.5% Commentators were quick to label Abbey's decision as irresponsible, and indicative of the current culture of debt among young people. The Abbey defended its decision by clarifying the criteria for this high multiple mortgage. The buyer(s) need to deposit 25% of the purchase price and have an income of £50,000. This seemingly puts the mortgage out of the reach of first time buyers, and indicates that the product is aimed at those with decent savings or an existing property, and a generous salary. If these people are attracted to a high multiple mortgage, it is more likely because they are looking to buy a bigger house than they could otherwise afford, rather than they are struggling to get onto the property ladder.

Abbey was not the first lender to offer such high multiples, and by no means does it offer the highest. Its decision hit the headlines because it is seen as a market leader, and will encourage the rest of the market to follow suit. Indeed, only a couple of weeks later the Co-Operative Bank announced its intention to allow borrowers a 5x multiple, based on similar criteria. The major lenders offering the highest multiples are;

• Northern Rock 5.1
• Abbey: 5
• Natwest 4.9
• Cheltenham and Gloucester 4.75
• Halifax 4.5

Lenders in the sub-prime market (i.e. those lending to people with poor credit ratings or county court judgments) will offer even higher multiples than these. Edeus, which operates in the sub-prime and near-prime markets, offers borrowers up to 6 x their joint multiple.

Lenders are claiming they feel confident offering these high multiples because they have improved the methods they use to assess the ability of a borrower to pay back the loan. This affordability model is becoming ever more dominant as lenders offer more and more loans. Lenders working with higher multiples usually start with a credit check. Providing there are no blemishes on the borrowers record, the lender will use other data such as current and potential earnings to work out how much they are prepared to lend. The problem with this system is that although it uses credit history as a starting point, it also makes predictions about future events, such as the borrowers salary will increase by x amount in x years, or the value of the property will be increased by x amount.

Loan to Value

There are also a growing number of lenders providing 'mezzanine' mortgages, that is, they will lend above the valuation of the property. HBOS, which owns Britain's biggest lender, Halifax, has recently introduced a mortgage of up to 125% of the value of the property, through Birmingham Midshires. Mortgages of over 100% loan to value have been available for some time lenders such as Northern Rock and the Coventry building Society. The HBOS 'Mortgage Plus' is geared towards young professionals and graduates, who theoretically have a high earning potential. The extra funds can be used to pay for furniture and decorating the new property, as well the high attendant costs of purchasing a house, including stamp duty, broker fees etc.

Borrowers taking out high LTV mortgages are making two assumptions. The first is that the housing market will remain buoyant and the value of their property will continue to increase. Indeed, if you are borrowing 125% of the property's value, the price of your property will need to increase by a quarter before the investment is a sound one. Set against the fantastic growth of recent year as described in the first section, this doesn't seem to be too much of a problem. If things continue as they are, then the borrower will be out of negative equity in around a decade. However, this is something of a leap of faith, as although the market doesn't yet show too many signs of crumbling, there is still a great deal of uncertainty among many high profile institutions and commentators.

Amid concerns that banks would not be fully prepared should a house price crash occur, the Financial Services Authority (FSA) has this month ordered banks to predict a hypothetical 40% crash in prices and assess how this would affect their business model. Last week, David Miles, a former advisor to Gordon Brown and chief UK economist at Morgan Stanley published a report arguing that current trends are unsustainable and house prices will fall sharply within the coming years. This is potentially disastrous for borrowers with high LTV mortgages, as they will be plunged into negative equity and their home will end up a financial liability rather the great investment many people currently see property as.

The second assumption made with 'Mortgage Plus' type loans is that the borrowers earnings will increase significantly and make the loan affordable. In today's competitive job market, simply being a graduate is not sufficient to secure you a stable job with a generous salary. Should someone who a lender has assessed as having high earning potential struggle to fulfill this perceived potential, they will be left with an unaffordable mortgage, and their home will be at risk of repossession. Between July and September this year, there were 19,687 repossessions orders issued (Dept of Constitutional Affairs), the highest figure since 1993.

No ceiling?

The housing market is in a sense self perpetuating; people see buying property as a good investment and are willing to take on debt in order to get onto the ladder, lenders are willing to give the debt, so demand stays high and prices keep increasing, which means people continue to be attracted to the perceived high returns of the market.

It can be hard, therefore, to see a ceiling on the housing market as it is in the UK at the moment. This lack of clarity may act as some comfort to people thinking about taking out high income multiple or LTV mortgages, but it shouldn't. If people's confidence in the ability of house prices to keep rising dips, then they are less likely to regard property as a sound investment and put their money elsewhere, the combined effects of which could result in a serious downturn in the market. This would be disastrous for first time buyers who have already taken the plunge and taken on a large debt to pay for their house. In a worst case scenario they will find themselves in thirty years with a property worth less than the huge mortgage they took out to pay for it.