How Heavy Is Your Home Loan?

With debt levels and interest rates both rising, homeowners are feeling the pinch. Can you see these danger signs?

When I see how far people have to stretch to climb the housing ladder these days, it makes me fear for their future. For example, a report out today from trade body the Council of Mortgage Lenders (CML) revealed that first-time buyers and home-movers are being forced to dig ever deeper to satisfy their housing aspirations.

Sky-high house prices mean that, on average, first-time buyers are now borrowing a record 3.33 times their pre-tax earnings to buy a home. What's more, with the Bank of England's base rate having risen from 4.50% last July to 5.50% today, interest payments now gobble up an average of 19% of a first-time buyer's pre-tax income. This is the highest level since 1991 (and home-movers are in the same boat), which doesn't bode well for today's late entrants to the housing game, especially when May's interest-rate rise is added to the mix.

Indeed, the more I look at the position facing first-time buyers (and to a lesser degree, home-movers), the more warning signs I see. Here are six questions to ask yourself about your home loan (or the potential mortgage for your next move):

1. How big is your loan compared to your income?

Although some mad mortgages allow you to borrow five, six, even seven times your gross income, I really wouldn't advise it. The more that you borrow, the higher the risk that you take on, so don't go over the top.

When interest rates were higher than they are now, I recommended borrowing no more than three times your pre-tax income. These days, I'd push the boat out to four times, but I wouldn't go beyond this, despite the obvious temptation to do so.

2. What proportion of your purchase price does your loan account for?

Ideally, you should put down a sizeable deposit to buy your home. A nice, round tenth (10%) is a good start and a quarter (25%) would be great, but even 5% will do.

Remember that if you don't have any deposit, then you don't have any initial stake in your property and your lender owns the lot -- at least, until the house becomes more valuable. Also, the larger your deposit, the larger your cushion when house prices fall, and the lower the risk that you'll end up in negative equity (when your mortgage exceeds the value of your home). So, avoid 100% mortgages if at all possible -- and don't even think about taking out one of these crazy home loans at 125% or 130% of the purchase price!

3. Can you afford a repayment mortgage, or just interest-only?

Monthly payments for a repayment mortgage are always higher than those for an interest-only loan, simply because the former include an additional amount which brings down your debt. For example, borrowing £150,000 over 25 years at a yearly interest rate of 6% would cost you £966.45 a month with a repayment mortgage, compared to £750 for an interest-only deal.

However, that extra £216.45 a month performs a vital task: it guarantees to pay off your debt after three hundred monthly repayments. Without it, you're simply renting your house from your lender and thus are entirely reliant on higher house prices to make you better off than a tenant. I'm sure you'll agree that this isn't an ideal situation to be in, so do make arrangements to pay off your home loan at some point in the future.

4. What percentage of your take-home pay do you spend on your mortgage?

I don't like the CML figure which I quoted above ('interest payments now gobble up an average of 19% of a first-time buyer's pre-tax income'). My concern is that this figure only looks at interest-only affordability in terms of a borrower's gross income before deductions. However, taxes have been rising in recent years, putting pressure on our take-home pay. Also, this figure only measures the interest bill, and ignores the considerable extra cost of actually paying off the debt.

Hence, I'd prefer to consider the cost of a repayment mortgage (or interest-only mortgage plus an associated repayment vehicle) as a proportion of your take-home pay. It's possible for someone to spend half (50%) of their take-home pay on their mortgage and still survive. Nevertheless, I reckon that, for most of us, the warning light would switch to amber when this proportion exceeded a third (33%) and would turn red at two-fifths (40%). This is based on my own experiences of being in court seeing people having their homes repossessed, as everyone fell into this 40%+ category.

5. Could you cope with rate shock?

If you're worried about the future direction of interest rates, then the simple answer is to take out a fixed-rate mortgage. But what happens when your fixed rate expires and you can't dodge a hefty rate hike? For example, the vast majority of the 1.3 million borrowers who took out a fixed-rate deal in 2005 face a rate hike this year or next of up to 1.5%. To avoid this 'payment shock', I'd recommend budgeting ahead for a rate 2% (or even 3-4%) higher than your current rate.

6. Are you relying too much on relatives?

I bought my first home with the kind help of my (future) father-in-law, who lent me my 10% deposit, plus £1,500 to cover other expenses, such as legal fees and so on. However, I repaid this money in full over the next five years, at a fair rate of interest.

If your parents or other relatives are helping you out with your mortgage, don't rely on them providing you with a 'soft' (non-repayable) loan. Play fair by offering to repay their gift over a preset period, or give them a proper stake in your property. Otherwise, you could be accused of taking advantage of their generosity -- and could leave them worse off when they come to retire.

Wow, I did all that preaching without mentioning the C-word -- 'crash', I mean. Oops, there it is!

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