Van Roy’s Law: “Honesty is the best policy – there’s less competition.”
Prologue - who is this book for
Any exposé of mortgages might hint at dark secrets implicating our largest institutions in dirty deeds. While there are indeed secrets and surprises, most of the news is good, apart from just a few naughties: for instance, the so-called endowment mortgage scandal is analysed. Some readers may want to jump immediately to the section on “How to be a Millionaire” but it will probably pay to be patient, and work up to it.
The principal aim of this compendium is to get into the basic structure of a loan or a mortgage, and explain how they are designed, costed and calculated. What are the hidden costs, if any, and what is their relevance? How should a borrower select just one product from the thousands offered by some one hundred different lenders? What really is a "best buy"? When is it worthwhile switching from one scheme to another?
The book does not set out to be a popularist treatment of mortgages. Rather, it aims to present readers with all the necessary tools and thought processes to enable them to come to their own, logical conclusions. It attempts to explain basic principles and facts rather than offer opinions and list opaque empirical rules, and focuses on those facts that are most often misinterpreted. It might seem complex in parts to some readers, yet over simple to others. It also dwells on a few novel concepts.
Mathematics is involved, but the formulae used to perform almost any calculation involving mortgages or loans is explained as simply as possible. Readers need no profound knowledge of mathematics, beyond a good level of numeracy to secondary school level. The purpose is to impart a better understanding of the generic anatomy of any loan as a financial product.
Access to a spreadsheet programme such as Excel or Lotus 123 is helpful, since a useful range of easy-to-use spreadsheets is included on a disk or, for web readers, as a free download. These sheets are designed to answer most of the important mortgage and loan questions without the need for any special spreadsheet knowledge.
The full power and sophistication offered by some more advanced mathematical methods is also included for completeness but not for necessity. Anyone professionally involved in the mortgage and loans business will hopefully find something of value. Borrowers with enquiring minds may find much to enlighten them. Technical terms are explained and the more complex parts are consolidated into a separate section called “Technical bits” in Part I, to insulate the merely curious from the technicians. Computer programmers may find some of the formulae discussed here to be useful for their work.
The fierce rivalry in the mortgage & loans business persists. Contemporary money supply mechanisms have ensured there is more cash available to lend than there are people wishing to borrow. As a result of this oversupply, lenders are constantly experimenting with innovative products to attract an increasingly discerning and Internet-aware consumer. The classic endowment mortgage has already fallen from grace and we will look at the pros and cons of this long running dilemma in more detail.
Today's loan products are far more sophisticated than ever before. Flexible payments, cashbacks, discounts, fixed rates, low starts, impaired credit, non-status, buy-to-let, shared appreciation, index linked, LIBOR linked and many more ideas go and come and occasionally reappear.
The Internet now provides a business channel that demands far closer attention to real value for money as well as comparing all the other key attributes of a well-designed mortgage or loan product. Mass customisation is now easy to automate on the World Wide Web. Never before has it been so essential to understand the numbers behind the numbers.
So what is the best deal for the borrower? What product is more attractive for the lender? How are the monthly payments calculated? What is the redemption amount? What is the Rule of 78? Is a re-mortgage worthwhile? What is the best product for an individual and is the new APR effective for this purpose? Is it worth borrowing to buy a rented property? What is gearing? Is it worth borrowing at all?
For the answers, read on. Check the spreadsheets and the on-line tools. These provide practical and dynamic examples of the maths in action in a simple, straightforward format, so all your personal “what if” questions are handled instantly. The whole treatise is available for downloading on this web site, including the spreadsheets. The downloaded version may well be more up-to-date.
From an early age I have always been fascinated with mathematics. The logic and preciseness of the essential thought processes were particularly comforting to an adolescent, trying to come to terms with a greater world, which seemed anything but logical.
But
it was especially delightful to discover later on that maths could be such an
intrinsically practical activity. It was possible to define real life
situations using mathematical formulae with a precision that could even take
account of the vagaries and unpredictability of real life.
For example,
the life insurance actuary possesses the skill to define a human life span in
terms of formulae on which a whole industry depends. Nothing is less
predictable than your own date of death, but when an actuary takes the human
tribe as a group, he would literally gamble his bonus on getting life expectancy
"dead" right. This rudimentary, but magical expertise is the fundamental basis
of the huge life insurance industry.
In the mid
sixties, I was a twenty something year old
Army officer with a Cambridge University degree in Engineering, but otherwise pretty unworldly. My wife and I were content with renting our modest, comfortable and subsidised Army quarter, especially as we paid neither interest to a lender nor premiums to an insurance company. I remember arguing with some equally naive insurance broker who was determined to sell me an endowment policy in preparation for a future mortgage.
Whilst this broker was very insistent that the endowment mortgage was the right stuff, my freshly educated mind was then expecting a simple mathematical proof, which he was not able to present. By then my whetted appetite demanded more knowledge. Eventually another broker convinced me to buy a house, and a life insurance policy, using a series of simple mathematical arguments that seemed stunningly conclusive.
I was so struck by the logical deductions in the sale process that I declared there and then that I wanted to leave the Army, buy a house (with the largest, longest, cheapest mortgage I could get) and then become a mortgage consultant and spread the gospel. This was in the late sixties, when most of my colleagues in the Services thought renting was the right thing to do. I was aching to convince them that there was a better alternative.
In those young, innocent days, my naïve excitement was almost like a missionary calling. I wanted to share my ingenuous, St.Paul-like conversion to the concept of house-purchase-by-mortgage with the entire world.
It was some years later when I realised that the successful early sales I had achieved was more to do with my rather transparent enthusiasm and not, as I then believed, the high minded logic that I had pompously considered as being so persuasive. My early clients, colleagues and friends, later confided that they actually had little idea what I was actually talking about from my initial sales patter. But they did admit to being caught up with my own zeal to the extent that they thought I must be "on to something" and so they bought my passionate story. I give thanks to those early, tolerant disciples, who luckily prospered from the housing market they were encouraged to enter.
I spent the first half of the seventies as a mortgage broker, and the second half dealing with more general financial planning and investments. I combined the two in 1979 by launching the first ever index-linked investment product (linked to the RPI or Retail Prices Index), which was underpinned by my concept of a residential index-linked mortgage. Our new company was initially named ILMI – which rather cumbersomely stood for the “Index Linked Mortgage and Investment Company Limited”.
Despite double-digit inflation, and before index-linked gilts were invented, the mortgage product proved more attractive than the investment, which then lacked the credibility of a brand name. Merchant bankers, Lazards, were later persuaded to sponsor the first RPI index-linked unit trust. Skandia Life also launched the first RPI linked pension fund. Both schemes used my index-linked mortgage concept, which ILMI both marketed and administered. The mortgage product is explained in more detail in Annex A.
The principal attraction of the index-linked mortgage was the low start. The initial monthly payment was around 30% lower than a "normal" mortgage and future payments were guaranteed to remain the same in "real" terms throughout the term, in other words, the true purchasing power was constant throughout the term.
The low initial payments permitted people to afford larger loans. In a decade when house prices moved only upwards, this method of loan also promised greater profits to the borrower. Falling house prices would (and did later) have the opposite effect.
The eighties proved to be a particularly exciting decade for the mortgage business that was then at its most innovative. The low start payment method was refined to attract conventional funding. Mortgage Systems Limited was born out of ILMI in 1981 to exploit the demand for a new style low start, flexible payment mortgage. The Thatcher years were more about investing than nesting, and the house purchase business was then booming. Mortgage products, particularly those that enabled you to obtain a larger mortgage for a lower cost, were in great demand. Mortgage Systems obliged by designing, marketing and processing applications for a whole range of low start, flexible payment mortgages for its many lenders, and we then provided an on-going mortgage administration service.
Adrian Bloomfield, the well-connected entrepreneur then running second mortgage lender Premier Portfolio, introduced me to John Gunn’s British & Commonwealth, a company determined to be a major force in financial services. They showed an interest in our still quite fledgling company. When we finally sold Mortgage Systems to British & Commonwealth in 1989 (who later went into administration and were forced to sell our old company on to the Skipton Building Society, who renamed it Homeloans Management Ltd), our 600 dedicated staff were managing over £3.5 billion of mortgages for around 20 worldwide institutions, occasionally processing over 2,000 new applications per week. But although now my main business passion had been sold, I was not yet quite ready for retirement.
1990’s
I joined the board of Mortgage Group Holdings, which then owned UK’s most popular mortgage broker, John Charcol, ably led by its clever founders, Johnny Garfield and Charles Wishart. I was already a non-executive director of Private Label Mortgage Services Limited, the hugely successful mortgage design and marketing operation run by the ebullient Stephen Knight.
Stephen & I attempted to launch a reverse mortgage scheme by founding a company called Home Income Trust PLC, with a product designed for asset rich, but cash poor, homeowners. But this turned out to be incredibly badly timed. House prices started to move downwards and some well-publicised scandals surrounding home income schemes frightened off both potential customers and their lawyers. Soon the public’s confidence in these plans all but collapsed so we withdrew the product and mothballed the company to wait for better times. The scheme still has merit, and is described herein.
A spell first as a consultant and then as a director of The Paragon Group in the late nineties (Paragon was previously NHL - National Home Loans - another company founded out of the exuberant mortgage market in the mid eighties) enabled me to experience for the first time life as a wholesale lender. NHL had expanded fast in the eighties. It was sales led, and it sold just about everything demanded by borrowers and mortgage brokers alike.
Unfortunately the subsequent house market collapse in 1990 left NHL exposed to the less reliable borrower, and massive arrears almost sunk the company. In the early nineties, a new and very able team of Directors gradually put the company back on its feet and the share price rebounded. Home Loans Direct was first formed to restart our lending programme (this was my new role) and now, as the renamed Paragon Group, we have successfully expanded, by both acquisition and organic growth, into other niches and consumer loan activities.
To lighten our load, my wife and I disposed of our interest in e-commerce & software specialists Dunstan Thomas Limited in May 2000 and resigned our directorships. With just a property investment company and a debt management company left, I am now sort of retired – well, shall I say “in a reflective phase”, but my early passion for the science of mortgage design still thrives. Consequently, while my recall system is still just able to function, I felt I wanted to set down and distil some of those early, but still valid, logical arguments in a more generic and understandable way and relate them to today's faster moving digital world.
So now, here we are with a book that is more about the numbers behind the scenes rather than the art of marketing mortgages. I hope I have made it interesting enough to encourage the reader to start using the spreadsheets included that are general purpose enough to be really practical, and the on-line tools on the web site.
I remember a well-known parable. If a man is starving, don’t just give him a fish, as this might only feed him for one day. Instead, give him a fishing rod, and show him how to use it, so he can then eat every day. I am attempting to offer you, dear reader, a fishing rod plus some instructions. Hopefully you will then be able to apply the techniques described here to fish for a better loan product, and encourage others to do the same.