Is a mortgage actually ‘good’ debt?
What does the explosion in mortgage debt mean for future property prices in Australia and highly geared homeowners.
“There is nothing as disturbing to ones well being and judgement than watching a friend get rich. Less it is to see a non- friend get richer”
- Charles Kindleberger
CBA caused a bit a stir in their August earnings release when they included slides in CEO Matt Comyn’s presentation that showed the stark differences between spending, net worth and debt levels between generations.
The commentary around the presentation is focused on the generational divide as young people are bearing the brunt of interest rate increases. And much of this commentary is focused on the world that one generation leaves behind for the next one. One legacy from baby boomers is the notion that taking on debt is a natural part of life and that it leads to good financial outcomes.
Conventional wisdom is that there is good debt and bad debt. Bad debt is used to finance consumption. Credit card debt is an example. Good debt is used to fund the purchase of an asset. That asset can be conceptual like the higher expected earnings that comes from education. Or it can fund the purchase of a house. A mortgage and loans to pay for education are two of the most cited forms of ‘good’ debt.
I disagree. I think all debt is bad. That doesn’t mean that there aren’t situations where people will go into debt. But the notion that certain types of debt are good has led us blindly down a path of amassing more and more debt. It has removed the impulse to pause and consider what constitutes an appropriate level of debt for each of us.
It is worth going back to the basics on debt. All debt lowers future standards of living. It is a self-imposed tax on future earnings. We can use a simple example. If I don’t have the cash to buy a $500 plane ticket and instead put it on a credit card with a 20% annual percentage rate (“APR”) I have exchanged the instant gratification of going somewhere with a future obligation.
If I pay $25 to my credit card it will take me 2 years and 1 month to pay for that flight. I will end up spending $601 and every month I have $25 less to spend. $25 a month probably wouldn’t dramatically impact the future standard of living of most people in Australia. But it is illustrative of the impact of debt. Maybe this is the right decision. Maybe it isn’t. But the starting point of considering taking on debt is that it has a negative impact on the future.
What makes debt ‘good’?
This notion that some debt can be good is a recent invention. And it is largely based on applying the lessons of the past on a vastly different current situation. In 1970 the average Sydney house cost $18,700. That was 4.5 times the average salary of $4,100. And we are talking about the average here which can be skewed upwards by extremely high salaries and highly priced houses.
But nevertheless, it is illustrative. If the average person wanted to buy the average home they would immediately run into a problem. A bank would not lend more than 2.5 times a person’s salary to buy a home. Lending more than that was not considered prudent at the time. That would limit the loan for the average person to $10,250. That means a down payment of $8,450. That is 2.06 times the salary of $4,100.
Interest rates in 1970 were 5.88%. That means a monthly mortgage payment of $60.66 or $728 a year. The average person would be paying a little more than 17% of their pre-tax annual salary on mortgage payments.
In terms of the impact on future standards of living the average person in the 1970s is signing up for a total future obligation of $21,839. That is paying back the $10,250 of principal and $11,589 in interest payments over 30 years. And this is a bit of a misnomer since it was more common at the time to get a 20-year mortgage. If the payments are affordable this is a better deal for a borrower because less interest is paid. But a 30-year term makes it easier to make a comparison. The $21,839 represents 5.32 years of pre-tax labour. When we combine it with saving for the down payment it means dedicating 7.38 years of pre-tax labour to purchase and fully pay off a house.
Lets fast forward to 2021. The average full-time earnings in Australia are $93,500. In Sydney the median house price is $1.31 million. The median unit is $824k. I will focus on the cheaper option of a unit. At $824k that is 8.8 times the average salary. That is below the income to loan ratio of most Australian cities.
To put down a 20% deposit and borrow the remainder at a 6% interest rate would result in monthly payments of ~50% of median income. Banks won’t lend that much and cap borrowing at around 30% of pre-tax income which equates to more than 4 times the annual salary. The definition of the amount a bank can prudently lend has changed since 1970 in the eyes of the regulator. It is unclear why borrowing more than 4 times your current pre-tax salary is now prudent.
To purchase the median unit in Sydney at the average salary would mean a loan of ~$390k and a down payment of $434k. To save the down payment would take 4.6 times the pre-tax salary of $93,500. Total monthly mortgage payments would be $2,338 or $28,058 a year. That is 30% of annual earnings.
Over the 30-year life of the mortgage at the current interest rate the borrower would be signing on to a future obligation of $841,768. That is paying back the principal of $390k and making total interest payments of $451,768. That represents a bit over 9 years of pre-tax salary. When we combine it with the years of savings up for the downpayment it represents 13.6 years of pre-tax salary to purchase a house and pay off the mortgage.
What is the impact of taking on this level of debt?
That is a question for each of us to decide. What we can say is that purchasing a unit in Sydney currently is significantly more expensive than purchasing a house in 1970 when compared to the average salary.
We can explore the practical implications of dedicating 13.6 years of pre-tax salary to purchasing a unit over a 40-year career. The first thing to consider is taxes. We can assume that 20% of a gross salary go to taxes. That means that over a 40-year career around 8 years of labour are spent paying taxes. Compulsory super contributions take roughly another 4 years of labour.
That is 25.6 years or 64% of all earnings going to housing, retirement savings at the government required minimum and paying taxes. It doesn’t leave a lot for food, clothes and medical expenses. To pay for transportation costs and maintaining a home. To pay for dependents and the inventible emergencies. To pay for whatever adds pleasure to life.
Astute readers may notice that I have not included any changes in income. House prices have increased significantly higher than income growth. That is why housing prices have gone from 5.5 times the average wage to 14 times for a house and 8.8 times for a unit in Sydney.
We do have to assume that income will grow over time. But it is also important to look at the timing of when the house is purchased. Buying a home at 25 is different than buying a home at 35. Income growth will be less over the remaining years of work. More years of salary have gone to housing in the form of rent.
Buy a house at 25 and assume 3% per annum increase in salary and it will add 27 years of additional “salary” at the average rate over a lifetime. That buys some breathing room even though inflation will eat away at the increased earnings as will taxes and higher super contributions. Buy a house at 35 and it only adds 12.5 years of additional “salary”.
More importantly, if a home is purchased too late it becomes harder to pay off prior to retirement. And that is where the financial freedom of owning a home kicks in. The average age of a first-time homeowner in Australia is now 36. In the year 2000 it was 24.5. The average age that an Australian retires is 55.4 years old. A 30-year mortgage taken at 36 would still have 11 years left at 55. It is safe to say that most new home buyers at 36 will not be able to retire at the same time as the previous generation.
Homeowners take on significant interest rate risk
Taking out a mortgage involves the assumption of a good deal of interest rate risk. Our hypothetical buyer in 1970 would experience this risk. The 5.88% mortgage rate in 1970 would be over 10% by 1975. By 1990 mortgage rates would be north of 15%.
The impact of changes in interest rates are proportional to the amount that was borrowed. A jump to a 10% rate would increase the monthly payment to $89.91 or $1,079 for a year for the person purchasing a home in 1970. That represents 26% of the $4,100 pre-tax salary. A significant increase but still below what a bank would ‘prudently’ lend you today.
The borrower in 2023 would see mortgage payment jump by $1,084 a month. That represents 44% of the $93,500 salary. Most borrowers would be looking for a second job. Something that 6.5% of all employed people already have in Australia. A mortgage rate of 10% seem unfathomable. But a borrower in 1970 would have been equally dumfounded if told rates in 20 years would have almost tripled. Anything can happen.
The larger the level of debt taken on the more personal interest rate risk a borrower is taking. The larger the level of debt the more overall financial stress on the borrower. Buying a house provides security to a homeowner. But at a certain level of debt the security associated with owning a home gets counteracted by the financial insecurity with taking on too much the debt. The level of debt that can be supported is individual to a borrower. But at some point, too much debt is a problem.
Isn’t a home the only way to build wealth?
Historically a home has been a pathway to build wealth. But we need to cut through the justification of home price appreciation stemming from migration or temporary supply shortages or Mark Twain’s pithy remark to ‘buy land, they aren’t making any more of it’.
The wealth has resulted from subsequent generations taking on more debt to buy the homes of previous generations. Yes, there were other contributing factors but housing prices would not be where they are today if people were not taking on significantly more debt than previous generations.
In Manias, Panics, and Crashes the authors comment that sharp increases in credit are directly related to increases in real estate prices. This cycle ends when heavily indebted owners are forced to sell at distressed prices.
In 1970 housing debt to GDP in Australia was around 10%. By 1990 it increased modestly to around 15% of GDP. After that it accelerated rapidly. By the turn of the millennium, it was around 40%. Today it is sitting above 90%. And the magnitude of debt is concentrated within a portion of homeowners as 31% of houses in Australia are owned outright.
To repeat the price appreciation of the past would require debt levels to keep rising. A home needs a buyer. And that buyer can only afford what they can afford. Only four countries in the world have a higher housing debt to GDP ratio than Australia. The United Kingdom, Switzerland, Macao and Denmark. Incidentally each of these countries has lower home ownership rates than Australia.
On a house price to income ratio Sydney is the third most expensive city in the world. Melbourne is sixth. Adelaide comes in at thirteenth followed by Brisbane at eighteenth and Perth at twenty-third. For residential property to continue to appreciate at a level that exceeds income growth more debt will have to be taken on by homebuyers.
Is it worth it? I've argued that many homeowners don't fully understand the financial reality of homeownership in this article.
Where do we go from here?
The focus of much of the commentary on the charts in CBA’s results presentation was on generational inequality. I think this is missing the point. Older people are always going to have more money than younger people. They have spent a lifetime converting their labour into wages and hopefully saved enough to increase their financial capital.
But the real debate should be on the source of much of the wealth that has been amassed. The average 65-year-old Australian’s net worth is tied up in their home. That housing wealth was not generated by intelligence or hard work. The origin of that wealth has been the massive amount of debt that has been taken on by subsequent generations to push housing prices higher. And that does not mean that baby boomers didn’t work hard. It does not mean that they didn’t sacrifice. But plenty of people work hard and sacrifice without getting a huge financial reward. It can be argued that future generations who won’t be able to retire at 55 as they are still paying off their homes will work harder and longer than baby boomers.
Amassing the debt that has enriched baby boomers has been facilitated by regulatory changes that allowed banks to lend more money to each homeowner. It has been facilitated by government tax programs that have severed the traditional relationship between rental income and housing prices through negative gearing.
It has been facilitated by a series of intellectually dishonest attempts at addressing the affordability of houses without reducing prices or slowing the increase in prices. Some programs allow young people to further mortgage their future by taking money out of super to pay for a house. Some allow them to borrow more money by putting down a lower down payment. These are not programs to increase the affordability of housing anymore than a pay day lender increases the affordability of day-to-day life.
A cynical interpretation of these government efforts at helping with house affordability without actually making a house more affordable is that they are designed to continue to enrich homeowners. Young homebuyers simply can’t take on more debt so the only avenue left is to somehow come up with more money to support downpayments.
The cover story of these efforts is that homeownership is beneficial to society. The global evidence for this is scant if we ignore the demographic and socioeconomic skew to homeownership. There are plenty of stable societies with low homeownership rates and strong rental protections. In Germany less than 50% of people own homes. Japan the homeownership rate is 55%. Only 42% of people in Switzerland are homeowners. Sweden, France, Denmark, South Korea, the UK, NZ and Austria all hove homeownership rates meaningfully below Australia.
A big risk to societal stability is increasing levels inequality. And the housing situation in Australia is furthering inequality. Younger Australians without access to the bank of mum and dad are finding it increasingly difficult to purchase a house. Homeownership rates in the bottom quintiles of income continue to fall. It is hard to sustain these differences without consequences in a country where such an emphasis is put on the value of homeownership. It alienates many people from society.
Source Australian home ownership; past reflections, future directions by Australian Housing and Urban Research Institute.
And if homeownership is the goal of housing policies in Australia it isn’t working. In the early 2000s the home ownership rate was 70%. It has since dropped to just above 67% and younger generations have rates well below those of previous generations at the same age. If the population as a whole was not aging in Australia the rate would be far lower. In a paper by the Australian Housing and Urban Research Institute titled Australian home ownership; past reflections, future directions the rate is projected to drop to 62% by 2030.
What does this mean for people considering the purchase of a house?
Homeownership is obviously not a Ponzi scheme. But it has taken on some characteristics of a Ponzi scheme where each generation of homeowners are being paid out by future generations taking on more and more debt. This has been enabled by the regulators and government policy and the cheerleaders for housing including banks with their huge mortgage loan books.
If housing price gains can’t be supported by a loan cap at 2.5 times earnings, then increase it to 4 times earnings. If a 20-year mortgage would result in payments too high for new homeowners, then increase the term of the mortgage to 30 years. If the societal norms of buying a house in your early 20s are impossible to achieve, then save for longer and buy a house at 36. Each of these changes significantly alters the financial outcomes of borrowers. Yet we use the returns achieved under completely different past conditions as a justification for current decision making.
The point of this article is not to suggest government policies. And it is not to disparage homeownership. It is to provide perspective on debt and the impact of debt on individual financial situations. And it is to suggest that past gains in housing that are used to justify the purchase of a home are based on a historic increase in debt that just can't happen again in the future. It is a call for younger generations to be like baby boomers. Don’t view a house as a lottery ticket. God knows they didn’t when they first purchased a home. Take a prudent amount of debt that won't put you into financial hardship and can be paid back prior to retirement.
The intellectual foundation to what has happened with debt levels in Australia is the notion that some debt is ‘good’. Therefore, any level of debt is fine as long as it results in ownership of an asset. That is simply not true. Are we at a dangerous level of debt? That is hard to answer on an aggregative level. But for a lot of borrowers the answer is yes.
The purchase of a house is one of the most important financial decisions most people will make in their lifetime. It is too big of a decision to outsource to a bank to determine the size of the loan. For many people borrowing less than the absolute loan limit offered is the right financial decision. Citigroup CEO Chuck Prince famously said during the mortgage frenzy in the US before the global financial crisis that when the music is playing you’ve got to get up and dance. This might be one dance that some prospective homeowners want to sit out.
As always, I welcome any feedback or thoughts at mark.lamonica1@morningstar.com. For more on housing read about why I'm happy renting or listen to our podcast episode on the trade-offs between inveting and paying off a mortgage.