This article was published on 11 June 2016. Some information may be out of date.

Q&As

  • Adding to already huge mortgages is playing with fire
  • It’s not interest rates but mortgage size that matters
  • Lack of family communication leads to big debt…
  • …so do pushy credit card providers

QAs US banks tried to attract business during 2001–7, they went into “low doc loans”, 100 per cent mortgages and even “no doc loans”, but the thing that caused many folk to lose their homes during 2007–11 was the use of adjustable rate mortgages.

Together with mortgage extensions to capitalise on increased home prices, folk borrowed more to go on holidays, buy new cars and do home improvements. When interest rates rose, house prices didn’t need to drop by much until they were “underwater”. And then many lost everything.

Almost all New Zealand mortgages are effectively adjustable rate, as the rate usually changes when a fixed term expires. So while we have reducing interest rates to lure young first home buyers into increased borrowing, it is nothing less than a potential future trap when interest rates rise.

Most young folk I know in their first home have been pinned down with mortgage repayments of over 50 per cent of salary for a couple of years. This, together with their rates, vehicle running, insurance and living costs, has turned youngsters who have been accustomed to the high life into easy fodder for banks to increase their mortgage advances.

Everyone I know in this category of homeowner is now using mortgage advances (euphemistically known as home equity release) for some aspect of their current lifestyle, and thereby living beyond their means. Obviously the temptation is irresistible.

Can parents not just warn their kids? Nope, I tried that. Everyone, they say, is doing this because interest rates are so low. We parents need to see prudential advice in the media to support us — hopefully through your column. Can you help?

By the way, checking the flow of financial information from USA, the introduction of new home mortgage incentives by banks is re-starting the risk elevating process… all over again. Do we never learn?

AIt’s strange. We seem to either “over-learn” — think of New Zealanders’ fear of investing in shares ever since the 1987 crash — or learn too little. People often say house prices don’t fall, but look at the graph. Every time the line goes below zero, that means prices went down.

So yes, I’m keen to help warn people of any age against adding to already huge mortgages. And it’s particularly scary if they’re using the extra money to buy cars or holidays. It wouldn’t be quite so bad if they were improving the property or investing in a business or something else that might grow in value. But even then, it’s worrying.

How might a couple lose everything? Let’s say Freida and Fred have bought a house for $800,000 with a mortgage of $600,000. Over several years — or less in the current Auckland market — the house value grows to around $950,000.

The couple feel rich. And they’re sick of cutting back on fun to make their mortgage payments. So they gradually borrow a further $100,000 for a new car, overseas trips, concerts, clothes, perhaps a boat. Their mortgage now totals nearly $700,000.

I say “nearly” because in the meantime they will have repaid some of their first loan. But in the early years of a 25 or 30-year table mortgage — the most common type — payments are almost all interest, so the principal stays high for years.

All goes fairly well for Freida and Fred, even if they’re struggling to make their even bigger mortgage repayments. Then a few changes happen — interest rates rise, immigration slows, and policy changes make property investing less attractive. The bubbly house prices plummet, and homes like theirs are fetching less than $650,000. (Don’t believe me? In the late 1980s I lost 30 per cent on a house in upmarket St Heliers.)

While F and F are uncomfortable with their “negative equity” situation — meaning they owe more than the house is worth — it doesn’t matter much as long as they can keep up the mortgage payments. In the end house prices will rise again.

Then Fred loses his job, and the only new job he can find pays a lot less. With rising interest rates, the mortgage payments become impossible. In desperation, the couple sell the house for just $600,000. They’ve lost their home and their initial $200,000 deposit, and still owe the bank almost $100,000.

As you say, it happens.

What might stop it — apart from us oldies warning the youngies — is if the Reserve Bank goes ahead with a debt-to-income ratio. Banks wouldn’t be allowed to lend mortgages of more than a multiple of a borrower’s annual income.

Currently in the UK, most home buyers can’t borrow more than 4.5 times their income. “If applied in Auckland, it would limit a typical family to a mortgage of no more than $400,000,” says Herald political reporter Isaac Davison.

Oops! That’s going to cut out almost all first home buyers. Perhaps we would have to start with a somewhat higher multiple.

But let’s not wait for such a measure. Owing hundreds of thousands of dollars is potentially dangerous to your financial health. Please, young borrowers, don’t jeopardise your investments in your homes by borrowing more.

QThe current era’s high house prices with large mortgages at a low interest rate are not as sustainable as the small mortgages at a high interest rate that we saw in the 1980s.

High interest rates compensate lenders for high inflation rates. The “real interest rate”, the gap between inflation and interest, does not vary by much over time. The major difference between now and then is how fast nominal dollar income is growing relative to debt incurred for purchases in the past.

The cost burden of home ownership over a lifetime relates entirely to the house price and the mortgage, not to the initial interest rate at all. If you borrow three times as much, it will swallow three times as much of your income over your lifetime.

Under the small loan, high inflation scenario of the 1980s, most borrowers paid the mortgage off early, because their dollar incomes were more than doubling every decade. The burden of payments relative to income lessened rapidly, freeing up discretionary income for family life’s inevitable cost challenges.

However, with today’s low inflation and income growth and large mortgages, households will be significantly burdened for twenty years or more. Constrained discretionary spending will have consequences for the macroeconomy, as well as for deprivation in the lives of generations of children.

On average, many households do experience “bad luck” over the decades, including an increase in interest rates — and the likelihood of bankruptcy as the result is increased manifold by a “new norm” of massive mortgage loans.

AYou make a good point, that back in the 1980s inflation was much higher than now. Pay rises were therefore large, and it got easier and easier to pay off a mortgage quickly.

Mind you, last week we were looking at conditions in 1989, and by then inflation was well below its peak of more than 18 per cent earlier in the decade. By 1992 inflation was down at around 2 per cent. So your argument is less valid than for someone who bought a house in the 1970s or early 80s.

Your concerns about big mortgages echo those of the previous correspondent.

More next week on house affordability.

QThe sister of your correspondent two weeks ago sounds like my brother:

  • Previously had a good income. Thus when it stopped, the family just kept their spending at that level, maybe vaguely hoping that their job/business would be restored.
  • Family dependants. The kids (and spouse) might not understand the new reduced income level — so still expect the old lifestyle.
  • Easy credit from the bank and credit cards etc. So when a kid expects to go with their friends on the expensive school camp, or the spouse expects to put on an expensive dinner party for friends, the options are to either have an argument with the kid/spouse, or just put it on the credit card.

Putting it on the credit card is the easier path. But soon all the cards are “full”.

So, rather than being an act of commission (eg taking up reckless big spending, even gambling), it is more often an act of omission — that is, not acting to reduce their spending in light of the reduced family income.

APeople reading this may be thinking, “He should have just explained the situation — especially to his wife, but also to the children.”

But that might not be easy. Pride and self esteem may have played a part.

Thanks for writing. It gives us more insight into how some people run up huge personal debt. I hope things finally came right. If not, read on.

QI got into a similar situation to your recent correspondent’s sister about 10 years ago, where my then-wife and I had racked up close to $180,000 on credit card and personal loan debt over the preceding six years.

How did it happen? Relying on up to eight credit cards as an easy fix for everyday spending when times were tough, when unemployment struck, or simply to survive as a family with young kids. And using credit rather than saving up and only buying what we had cash for.

How did it get to that level? Credit card companies saw us as easy targets, with regular increased credit limits, new flash credit cards sent to us every six months, and the monthly balancing act of cash advances from one credit card to pay the minimum due for another card.

How did we get out of it? Only through the help of a financially-literate friend who negotiated with our debtors, frozen interest payments, reaching full and final settlements and sheer hard work to pay off more than $150,000.

Result — debt free, able to buy back into the property market, and the freedom that can only come with being out of the mercenary grip of banks, financial institutions and debt collectors.

AI appreciate your courage in writing about this. As I’m sure you know, your $180,000 total will shock many readers.

The credit card companies have a lot to answer for. While buyers should always beware, some sellers are unscrupulous about using psychological tactics to entice buyers.

I hope the Responsible Lending Code, which came into effect a year ago, is changing credit card pushers’ behaviour.

“The changes aim to prevent consumers being locked into loans they can’t afford and may have little hope of repaying,” says an article on the Consumer NZ website. “They’re also designed to stamp out ads for ‘easy credit’ that target low-income consumers and vulnerable borrowers unable to obtain finance from banks.” To read the article, go to tinyurl.com/NZlending.

Thank goodness your friend came to your aid. Others who don’t have such a friend should contact the NZ Federation of Family Budgeting Services, as I mentioned a couple of weeks ago.

I understand that the counsellors there sometimes negotiate in much the same way as your friend did. If lenders know that a debtor has a plan to repay them, they will sometimes suspend interest and even forgive some of the debt.

Mary Holm is a freelance journalist, a director of the Financial Markets Authority and Financial Services Complaints Ltd FSCL, a seminar presenter and a bestselling author on personal finance. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to [email protected] or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.