Comparing apples to apples
People are generally rational. If all else were equal, they would make choices in an effort to obtain outcomes that reflect their best interests. This is particularly true when these are choices about things that are important in their lives and readily quantifiable. We are working on home purchase plans to empower a generation of aspiring homeowners to make better choices. Ownership is important and the mathematics driving these choices are not challenging for people with a modicum of numeracy and clear calculation tools at their disposal.
Our starting point is simple: Most renters would rather be owners. In this article, I argue that they ought to buy homes as renting is considerably more expensive than owning. The fact that so few people "elect" to buy is evidence that all is not equal. Formidable barriers block people from acting in their best interest. Our daysrent? plans remove these barriers. Read on to find out how.
Rental affordability: The typical tenant forks out 35% of their income to pay rent. Averages rarely tell the whole story. Some excellent research by Canopy shows substantial regional disparities. Their analysis highlights boroughs in London where renters hand over more than half their income to their landlords. For context, according to Canopy , lettings agents regard 40% of gross monthly income as the upper limit for rental affordability.
The deposit hurdle: Some renters set aside 15% of their income – month after month for several years – to build up a deposit. Some save less for longer. Combining (a) rent in places that are relatively affordable and (b) recurrent deposit savings, many aspiring buyers devote half their income towards their current and future accommodation. You can't buy a home doing things by halves.
Rational choices: UK Finance data for the first quarter of 2024 indicates that first-time buyers in England devote an average of 22% of their income to repaying their mortgages. People fed up with renting would be well advised to buy a home. All else being equal, it's cheaper. Since the peasants have no bread, let them eat cake!
But all is not equal. Banks are very selective. On average, first-time borrowers in places like Newcastle and Sunderland, in England's North East, earn around 50% more than the local median income. Down in London, first-time borrowers earn more than double the local median income. And it pays to bear in mind that (a) local median income for the 85% of families that reside outside London is considerably lower than the national median and (b) most renters earn less than their local median income.
Apples to Apples: It is not easy to compare rental and house-buying affordability but here's my take. Banks rarely lend more than 95% of the value of the home and some people buy their first home in cash. Averaging out these two extremes, UK Finance estimates that loans to first-time buyers fund 75% of the purchase price. Meanwhile, a rental agreement is analogous to a 100% loan-to-value mortgage ("LTV"). To make an apples-to-apples comparison, we need to gross the numbers up.
Do try this at home folks: Let's divide the 22% of income that borrowers devote to repaying a mortgage by the 75% LTV ratio. In other words, in a world with no deposit requirement, from one day to the next, a first-time buyer could stop paying 35% of their income in rent and start paying 29% of their income to service a 100% LTV mortgage. No deposit? No problem. Even after this adjustment, buying is cheaper than renting.
Averages can be misleading: Let's go back to the regional disparities laid out in Canopy's report. This chart compares the cost of servicing a mortgage to the cost of renting, both expressed as percentages of household income. The data cherry-picks the three most and least expensive of England's three hundred odd local district areas.
This analysis confirms that buying remains cheaper than renting even in areas where renting is relatively affordable. To buy or not to buy? Only Hamlet would wrestle with that decision.
Does the Loan to Income cap fit? The UK Finance data also shows some regional variation in the cost of servicing the "typical loan." Where do these variations come from? They are more illusory than real, given that they are created by an arbitrary loan to income ("LTI") cap; along with minor differences in the length of repayment mortgages. Quite likely, people take out longer term mortgages in places where property prices are higher. Leaving that to one side, the LTI cap is the most important barrier preventing renters from becoming owners.
Strap in. This gets bumpy. All banks are barred from lending more than 4.5 times the applicant's income. There are rare exceptions but actual LTI multiples come in well under the cap because banks are incredibly conservative. In later articles, we will dive into the standard variable rate regime that banks use to determine what (in their view) the applicant can afford.
For now, the UK Finance data illustrates that achieved LTI ratios in the first quarter of 2024 span averages of:
To buy a decent place, you need to chuck in a large deposit in cash, and loan to value ratios vary widely. So, to make an apples-to-apples comparison, one needs to gross up to a 100% LTV mortgage. After this adjustment, the LTI multiples improve to:
These variations reflect the difficulty first-time buyers face trying to ascend Jacob's Ladder in places where property prices are vastly higher than the LTI cap. The chart below shows that house price to income ratios differ from place to place and are not static over time.
The LTI multiple is pernicious because this second arbitrary barrier reinforces the first. It's not sufficient to have "some" deposit savings. The house hunter needs to have sufficient savings to buy a suitable home. As homes cost different amounts, depending on location, and British trains are expensive and unreliable, the aspiring home buyer needs to move or save a lot more money than the amount required to buy any old home. The gap between the house price to income ratio and the LTI cap overstates the risks to banks of exceeding the cap. We know this because people rent homes all over these fair isles and (with rare exceptions) people do not get evicted for non payment.
During this enforced savings period, house prices keep rising. For offending the gods, Tantalus was made to stand in a pool of water beneath a fruit tree with low branches, with the fruit ever eluding his grasp, and the water always receding before he could take a drink. Homeownership is similarly tantalisingly close but ever elusive for too many renters.
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Movement at the station: In my view, the 4.5x income cap is no longer fit for purpose. What social good does it serve? There are exceptions. The Bank of England's Prudential Regulation Authority allows banks to exceed the LTI cap with respect to a maximum of 15% of their total loan portfolio. Moreover, in recent weeks:
These initiatives are laudable. That said, I imagine much of the 15% bucket had already been allocated to existing customers. If true, both these giants will need time to put money to work on behalf of new first-time borrowers.
Collateral damage: Regular readers of my posts will know that the mortgage deposit is a fictive construct that plays no measurable role protecting banks from default. See All Rise in which I run through and quantify the risk that banks will lose money in a default scenario with or without a deposit. This sounds controversial to some but let's debunk that by looking at an alternative way of helping people buy a home.
To someone armed with GCSE maths, this analysis suggests that a reliable renter ought to use this ￡160,000 to buy into their new home from the get go, rather than saving for a deposit. With a well defined home financing contract, the rational renter could choose to pay ￡160,000 or any other amount they feel is comfortably affordable to an institution willing to offer them something more valuable than rental accommodation in return, with or without a deposit. That institution could cover the risk of lending without a deposit by offering a lower reward in exchange for this inherently affordable ten-year strip of income.
Back on Planet Earth: Banks don't lend without collateral. In theory, the deposit improves the likely future value of that collateral from the bank's perspective. In practice, this collateral is rarely called on. Meanwhile, from the customer's perspective, the insistence on this mathematically redundant prophylactic forces renters to make poor choices – month after month for years on end. This weird insistence on collateral is doing a lot of damage.
Keep it simple, Stewart: This elaborate skein of rules exists to ensure that banks don't lend too much to people overly keen to buy a home. At the same time, we walk among renters who are (a) relatively poorer than those with the means to buy and (b) compelled to hand over more of their hard-earned income to occupy homes they will never own.
No skein of rules protects the more vulnerable of the two communities from paying more than they can afford in rent. No such rent control caps are in the offing as part of the renters' rights legislation wending its way through Parliament. And yet, renters pay their rent. Every family would be delighted if their landlord suddenly reduced the rent for no particular reason but, absent such largesse, renters just get on with it. The data hides in plain sight. If the Office of National Statistics is to be believed, Landlords made 25,000 county court repossession claims in the three months to June 2024 and some 7,000 homes were repossessed. In a nation with ten million renters, this cascade of default adds up to 1% and 0.3% per annum respectively. Is it just me or do these risks seem survivable on a portfolio basis for a well-funded institution?
There has to be a better way: As luck would have it, here's one we baked earlier. Imagine a world in which a reliable renter could set their own budget at any percentage of their income they think is affordable. Imagine a search engine (rather like a Rightmove or a Zoopla) where the aspiring homeowner could spend a few minutes going through a "rent-like" search for places to buy:
In such a world, the landlord could provide a palace or a hovel in exchange for the amount the applicant considers affordable (and not a penny more). Given a list of places to choose from, the rational renter would choose the palace. In so doing the "palace to income" ratio would greatly exceed the 4.5x LTI cap but the amount the occupant would pay from month to month would be anchored, rendering the cap obsolete.
Social inclusion for beginners. With our daysrent? purchase plans, the applicant sets their own monthly budget. No deposit? No problem. This allows the applicant to "magically" lower their rent and still end up owning a home. Our platform flags homes that straddle the "palace to hovel" spectrum. This allows the applicant to choose their own palace-to-income multiple. As we control the list of options, it falls to us to balance the need to provide homes we can afford to finance (hovels) versus homes that the rational renter would prefer to own (palaces) if they (like most renters) have no access to a mortgage.
Do a little maths: Going back to our ￡160,000 example. We cap our daysrent? plans at 40 years. Thus, the occupant's share of the sales proceeds would be at least 25% if they choose to sell after ten years because – drum roll – ten divided by forty equals 25%. The only decision the applicant needs to make is which palace or hovel they would like to occupy during those ten years. To make the game more interesting, we adjust the length of the pathway to ownership such that it takes longer to buy the palace versus the hovel.
You set the rent and we set the length of the pathway to ownership, calibrated in daysrent? points
Our formula takes account of the wide regional variations in house price-to-income ratios. And we fully expect to suffer the relatively small default rates that other landlords endure, so we make small adjustments to the number of daysrent? points we demand for each palace or hovel flagged as options on the map. Yes, that's a lot to think about so we have built a calculation engine to make the calculus and trigonometry intelligible to people who are highly motivated to rent their way to ownership. But for context, it takes between several days and several weeks of professional advice to obtain a mortgage offer. Our gamified system is better, faster, cheaper, and far more rational.
In later articles, we'll explain how our formula makes homeownership a little less tantalising and far more attainable.
Meanwhile, people affected by these issues should reach out and call me. ??
As ever: #fintechinnovation begins at home.
Ike Udechuku | Cofounder | CEO | The Pathway Club