FOOL'S EYE VIEW
A Simpler, Stronger Housing Market

By Cliff D'Arcy
June 17, 2003

Our houses are very, very important, and not only because they provide us with shelter. Housing wealth is a crucial part of our net wealth and housing-related expenses (mortgage and rent payments) account for a major slice of our household spending.

In the UK, around two-thirds (68%) of homes are owner-occupied; partly thanks to Thatcherism, we're a nation of proud homeowners. What's more, our housing equity (the value of our homes less our mortgages) reached a tidy £2,058 billion at the end of last year - that's a mind-blowing two trillion pounds!

The capital tied up in our homes also accounts for over 45% of our entire wealth, so housing is Britain's biggest asset. This explains why many UK homeowners welcome house-price rises, while most home-movers and homebuyers (especially first-time buyers) complain about sky-high prices.

Nevertheless, the government recognises that the "boom and bust" house-price cycle of the last twenty years has caused problems for large numbers of UK citizens. For this reason, in his recent Budget, the chancellor announced a review into reform of the UK housing market. As well as investigating house building and planning, he wants to increase the take-up of fixed-rate mortgages by UK homebuyers.

Uncle Gordon Brown thinks that UK homebuyers could learn a lot from the more stable models embraced by the US, Germany and other European states. In these countries, particularly in Scandinavia, borrowers almost always buy fixed-rate mortgages and switch to cheaper fixed-rate deals when interest rates are cut.

Let's take a look at how the UK's housing market differs from those on the Continent:

1. The level of UK home-ownership is high

Though the UK does not have the highest level of home-ownership in the European Union: according to the European Mortgage Federation (EMF), 85% of Spaniards, 80% of Greeks, 78% of Irish and 72% of Belgians are homeowners.

Contrast these figures with those of Germany, where less than two out of five citizens (39%) own their homes. (This rings true with me, as I lived in Germany for much of my youth; my German friends found the British desire to become a homeowner most peculiar!)

Across the EU, the average is 61%, seven percentage points below the UK level. There's no doubt that the British mentality that everyone has the "right" to buy a home has contributed to increased demand for housing and fuelled our "boom and bust" cycle.

2. Europeans don't borrow at variable rates (read more on mortgage types here)

One thing that strikes me is that we Brits have much greater appetites for risk than our European friends. According to the EMF, over seven out of ten UK mortgages (72%) are variable-rate loans, including standard-variable, discounted-variable, capped and tracker loans.

Also, we tend to look at the initial monthly payments when comparing mortgages, instead of looking at the long-term cost of our loans. This means we tend to focus too much on the short-term and ignore the benefits of long-term fixes.

Compare our situation to that in Germany, Spain and Italy, where variable-rate loans don't exist (to all intents and purposes). Our Continental counterparts customarily arrange their home loans on a fixed-rate basis: in Germany, all loans are fixed, usually for a term of between five and thirty years. In France, 14% of loans are variable, with the remainder fixed, typically for between five and ten years.

Additionally, most European mortgages have minimal redemption penalties (fines for prematurely settling loans early). This enables borrowers to switch with ease and thus avoid being locked in to uncompetitive deals. So, in countries like Denmark, rises in interest rates are not greeted by sensationalist headlines in the media, as long-term fixed-rate loans protect borrowers from sudden hikes in monthly repayments.

What's more, when interest rates fall, the Danes re-mortgage en masse and benefit from reduced monthly repayments. Doesn't that sound healthier than our helter-skelter system?

The government wants British mortgage lenders to offer loans that fix payments for the full 25-year term of a typical mortgage, offering complete payment certainty to borrowers. Some lenders have already done this, notably Standard Life Bank with its "Future Perfect" product.

However, in order to widen the availability of long-term fixes, UK lenders would probably have to go to the capital markets to "securitise" their mortgages - bundling them up and selling them to investors in the form of bonds. Some lenders do this already, notably Northern Rock (LSE: NRK)

Some commentators believe that the UK's obsession with variable-rate loans could be a major hurdle to joining the single currency. Clearly, the chancellor is convinced that if we continue to borrow at variable rates, UK house prices will continue to fluctuate widely.

3. We're more indebted than most EU homeowners

As we mentioned in this article, UK mortgage debt hit £700 billion in April (throw in a further £160 billion in loans and card debt and you've got an £860 billion debt gorilla)!

According to the European Central Bank, the UK's ratio of mortgage debt to gross domestic product (GDP, the value of all the goods and services we produce) was around 60% in 2001. This measure of how indebted we are was much greater for the UK than other EU countries.

Our ratio was beaten only by the Netherlands (at 74%) and Denmark (at 67%). In Italy, it was a mere 10%, in Greece, 12%. The European average is 39%, which suggests that we carry about 50% more mortgage debt than our Continental cousins.

4. UK house-price inflation is strong

(You can read more about the history of UK house prices here.)

From 1980 to 2001, annualised UK house-price growth after accounting for inflation (the "real" growth rate) was 3%. Compare our returns to other European countries:

• Sweden: -0.2% (1980-2001) - house prices actually fell over a 21-year period!
• Germany: 0.5% (1980-2001)
• Italy: 1.2% (1980-2001)
• France: 1.4% (1980-2001)
• UK: 3% (1980-2001)
• Greece: 3.5% (1994-2001)
• Ireland: 3.7% (1980-2001) - reflecting the success of the "Celtic Tiger" economy
• Spain: 4.2% (1987-2001) - UK buying of holiday homes may have been a factor

Strong house-price inflation can be a problem if it outpaces earnings growth: if house prices are rising by 10% a year and wages at only 5%, an affordability gap will soon develop. As it happens, UK house prices soared in 2002, rising over 25%, while average salaries increased by around 4% - eek!

So, it looks as if we will soon be moving towards a more stable mortgage market and, therefore, a steadier housing market. No doubt this process will take years so, in the meantime, Foolish mortgage payers will continue to re-mortgage in order to make their home loans earn their keep.

More: Mortgage Guide | Offset Mortgages

Many thanks to Christopher Adams and the Financial Times for the inspiration for this article.