## Monday, October 24, 2011

### New Beginning Mortgage Proposal

We have previously looked at the mortgage proposal from the New Beginning group (here and here).  Revised details of the proposal have been circulated.  Following our previous analysis the key peace of information is that the interest rate on the example we worked through is 3.55% rather than the 4.29% that was assumed in the previous posts.

“Compound interest” is the answer attributed to Albert Einstein when apparently asked what he thought mankind’s greatest invention was.  Just three-quarters of a percentage point may seem like a small change but in a mortgage such a difference can have a massive effect.

Our initial assumption came from the fact that Ken’s repayment was given as €1,450 per month and that he had borrowed €315,000 over 35 years.  If you plug these into a mortgage calculator the required interest rate is 4.29%.  This was further supported when the starting payment of €840 was the interest-only payment on the non-shelved mortgage of €215,000 at 4.29%  but this appears to have been nothing more than a remarkable coincidence.

The updated information indicated that Ken’s actual mortgage payment is €1,387.61 per month rather than €1,450, that the interest rate is 3.55%.  It is still assumed the case that the €315,000 is to be paid off over 31 years.

If the interest rate was 4.29% it would take total payments of €570,000 to repay the full amount over 31 years under the conditions of a typical mortgage.  If the interest rate is 3.55% the same mortgage can be repaid with €520,000.

The New Beginning proposal is that Ken’s monthly payment be immediately reduced to €840 and that this is applied to a mortgage of €235,000.  Ken monthly payment increases by 3% per year and the €80,000 of the mortgage that is “shelved” is repaid in instalments beginning in year 10.

First up here is what happens to the €235,000 loan using the New Beginning figures.  The actual annual payment increase is 3.0595% rather than just 3% and this continues until the payments reach €1,135.48 from the start of year 11.

The €235,000 is paid off over the 31 year term of the loan (with eight months to spare).  This requires payments of just over €402,000.  Again it should be remembered that the loan can be paid off for less if a standard mortgage repayment schedule is applied.  However, in this case a typical mortgage of €235,000 at 3.55% over 31 years would require €388,000 of repayments.  The difference is only €14,000 and the benefit of the reduced payments early in the term is likely to be useful to someone who is having temporary difficulty in meeting their mortgage commitments now.

What about the €80,000 that was put on the shelf?

This is repaid in four short-term loans beginning from year ten.  These are five-year loans where some of the €80,000 is taken off the shelf and repaid at 3.55%.  The rest of the money stays on the shelf and no interest is charged.  The proposed repayment schedule is

Essentially Ken the borrower gets €80,000 interest free for ten years (cost €34,034 at 3.55%), €97,778  (equal to €80,000 + €34,034 – €16,256) interest free for a further five years (cost €18,961), €98,207 interest free for a further five years (cost €19,044), €96,124 interest free for a another five years (cost €18,640) and €90,679 interest free for ever more but the cost for the final six years of the mortgage is €17,584.

All told the bank has foregone €108,263 of payments over the 31 years of the mortgage.  The interest costs of this will continue into perpetuity.

All told the borrower will have made €402,000 of payments on the mortgage and €87,000 of payments on the shelved loans over the 31 years of the plan.  If this €489,000 had been used to repay a standard mortgage over the same time it would repay a mortgage of €296,000 at 3.55%, just €19,000 below the original loan of €315,000.

How much of the €315,000 if the New Beginning repayment schedule was applied to the full amount of the loan?   In this instance the repayments will be around €103,000 short of repaying the mortgage in full.

The benefit of the New Beginning scheme to the borrower is just over €100,000.  This can be shown as either the benefit of having borrowed money put “on the shelf” at no interest cost or the amount that would be left on the mortgage if the New Beginning repayment schedule was applied to the original loan.

It should also be remember that most of the benefit accrues to the borrower from having money borrowed from the bank for longer.  The total amount of repayments are very similar: €520,000 to repay a standard €315,000 mortgage at 3.55% over 31 years versus €489,000 to repay under the New Beginning split mortgage scheme.

The borrower gains around €30,000 from making lower repayments, but because more of the payments are made later the actual benefit is north of €100,000.  The power of interest rates is shown when compared to our previous analysis.  With an interest rate of 4.29% the benefit of the scheme was estimated at around €280,000 for Ken.

A truer measure of the benefit of the scheme to the borrower (and hence the cost to the bank) is just over €100,000.  The overall cost of implementing such a scheme depends on how many “Ken’s” there are.  For every 10,000 that enter the scheme the cost to be covered is €1 billion.

The scheme is not as off the wall as the original analysis indicated.  €100,000 is a lot of money but it may be a price worth paying as a solution to the current crisis.  The scheme has some merit and it could be adapted so that some of the costs incurred early in the term can be recouped with higher payments later in the term of the loan – 31 years is a long time.

Still, though if we are going to reduce the mortgage burden on some people why make it so complicated?   If we want to save someone €100,000 on their mortgage why not just reduce the balance upfront.  Ken would save €100,000 on repayments over 31 years if his current mortgage was simply reduced from €315,000 to €255,000 – it’s just debt forgiveness.

As we said above the borrower also benefits from the reduced payments early in the term so the reduction will be less, probably to around €275,000.  So we could follow the New Beginning repayment scheme or just knock €40,000 off the mortgage now.  There is no difference.

1. How do you figure the cost at 100k?

Surely setting a fixed mortgage interest rate of 3.55% over thirty years is also a cost?

2. Hi yogan,

The interest rate on the mortgage is 3.55%; it does not need to be changed. We are not told what of mortgage it is: fixed, standard variable or tracker. The best prediction of future rates is the current rate. The rate could (will) change but I don't know when or by how much so I just applied the current rate for the entire mortgage.

As I said in the previous post the New Beginning plan is dependent on a number of things. One of these is that the interest rate does not rise above the starting level. The second is that net disposable income grows at 3% per annum. Neither of these is guaranteed. if interest rates rise or payments cannot rise at 3% per annum then the costs will be greater than €100k.

3. Hi Seamus

"The best prediction of future rates is the current rate."
Well, you can work out interest rates based on 30 year swaps = 4ish% plus margin plus fixed rate cost, so about 7%?

You could guesstimate from them over the 30 years as being current 30 year rate plus margin = about 6%?

Anything else does not give an accurate picture of costs, which is what you are trying to do. As you say, and I agree, a small change in the interest rate has big effects. Taking, though, the lowest possible rate (current interest rates) and extrapolating them forward is not going to give an accurate answer.

No?

4. Hi yogan,

I agree with all of the above.

In the early years of the New Beginning proposal it would not take a huge increase in the interest rate to push the monthly interest amount above the repayment allowed by the 35% rule. In that case the mortgage would start to increase and could do so for a number of years until income growth (which is necessary) would allow the payment to exceed the interest amount.

A higher interest rate (or lower income growth) would mean that the mortgage would not be repaid within the agreed term. This means that either the cost to the bank has to be greater or the borrower has to repay more. In that sense the level of repayment and cost to the bank given above could be construed as a minimum.

5. Hi Seamus,

Yep, NB's 'solution' is a form of debt forgiveness (though from a bank perspective it’s preferable to have a deferred forgiveness than upfront). The NB proposal is complicated. I note there’s a good chunk interest free for 20+ years. I reckon the 4 loans to cover the 80k would have an approx(rough work) present value of 30k using a 5% discount rate. A 50k write-off (pv) on a performing loan (loss rate = 18%) is a lot. Especially when the loan could default subsequently. It’s hard to see how this proposal won’t increase total loss rates.

On a general level, I'd make the following observations:
1. NB’s proposal seems to extend beyond non-performing mortgages.
2. The NB proposal doesn't really deal with negative equity. It deals with affordability.
3. Using percentage of net income is not the best metric. It's common in some countries to calculate an amount for monthly outgoings with the excess being available for mortgage payments. If you net monthly income is 5k, you should be able to afford more than 35%.
4. Using 35% of net income cushions these mortgage holders from austerity measures being imposed on the rest of the population. ASAIK private renters have had their net income reduced, but don’t get a bail-out.
5. I don’t believe it will increase consumer spending, I’d expect the beneficiaries to save.
6. Is there a clawback for the bank if a person’s finances improve?
7. What number of mortgages are we talking about?
8. It’s difficult to see why banks would prefer NB’s proposal over an interest only option.

6. Fair enough, thank you.

When the best case is 30 years, you know you're stir crazy...

7. Hi Seamus,

I have been following the thread and also the new beginnings 'solution'.
There are two points I would like to throw into the mix,
Firstly new beginnings 35% of income to service debt is based broadly around the financial regulator’s maximum allowed guidelines over the last number of years (although if memory serves it is actually a maximum of 40% of Net Disposable Income for all debt servicing) In other words no lender should have given a mortgage of more than 40% of net income.
Therefore, the argument follows that nobody should now have a higher repayment burden than 35%.
To my mind there is some merit in this argument.

Secondly and more importantly the rates quoted on Ken’s mortgage at say the 3.55% includes profit or margin for the lender.
With ECB rates currently at 1.5% this implies an administration margin of 2.05%.

For some time I have been working on an idea around this very point which broadly would run as follows.
• State owned lenders and by invitation the other MARP operators would forego their profit/margin save perhaps for say a 0.5% administration margin charge.
• The mortgagee would pay 40% of net disposable income proportioned against capital and interest
• Paid on an interest first capital second basis
• If Interest only repayment is greater than 40% NDI consider warehousing, viability of mortgage, or dependent on circumstances i.e. Single person increased NDI to 50%
• This would be adjusted annually based on previous year P60 or tax returns
• Reviewed periodically and where applicable administration margin increased or scheme deemed no longer necessary where income/affordability improves.
• Systematic or continued failure to adhere would result in revocation of the scheme.

In Ken’s example this equates to €960 available for debt servicing, proportioned €525 against interest and €435 against capital. This would result in a shortfall per month of €177 therefore as Ken is single and I am assuming no dependents consideration can be given to an increased NDI of 47%. In married examples or where there are dependents some warehousing could be considered.

The thought process here is the immediate burden shifts from the mortgagee to the lenders/state, who in theory shouldn’t profit from this crisis. There is still pain being felt by all parties but there are also incentives for both sides now and going forward.
Inevitably there will be hidden costs or lower operating profits from the loss of revenue, it reflects some burden sharing and ownership of at least part of the blame by the lenders.
Also as it is a drip feed it may be more sustainable than any drastic upfront schemes which clearly can’t be borne presently.
Obviously it is not a fix all but could be considered another tool.

Emmet Ec2101

8. Yep, NB's 'solution' is a form of debt forgiveness (though from a bank perspective it’s preferable to have a deferred forgiveness than upfront). The NB proposal is complicated. I note there’s a good chunk interest free for 20+ years. I reckon the 4 loans to cover the 80k would have an approx(rough work) present value of 30k using a 5% discount rate. A 50k write-off (pv) on a performing loan (loss rate = 18%) is a lot. Especially when the loan could default subsequently. It’s hard to see how this proposal won’t increase total loss rates.

On a general level, I'd make the following observations:

1. NB’s proposal seems to extend beyond non-performing mortgages.

2. The NB proposal doesn't really deal with negative equity. It deals with affordability.

3. Using percentage of net income is not the best metric. It's common in some countries to calculate an amount for monthly outgoings with the excess being available for mortgage payments. If you net monthly income is 5k, you should be able to afford more than 35%.

4. Using 35% of net income cushions these mortgage holders from austerity measures being imposed on the rest of the population. ASAIK private renters have had their net income reduced, but don’t get a bail-out.

5. I don’t believe it will increase consumer spending, I’d expect the beneficiaries to save.

6. Is there a clawback for the bank if a person’s finances improve?

7. What number of mortgages are we talking about?

8. It’s difficult to see why banks would prefer NB’s proposal over an interest only option.

9. What are the implications for future mortgage lending? If (as seems to be the case) that the government plans to issue something more than guidelines to banks, will lenders want to lend? On the face of it lenders could face losses on performing loans.