Buying a home with a small deposit can be appealing. But this can you leave you open to extra problems and what’s called a low value mortgage.
In the US, 41% of Millennial first home buyers regret their purchase. It’s not because of the maintenance, or location, or size of the house; but because their monthly mortgage repayments are too high. This is a complex problem and it’s not due to smashed avocado on toast and issues with managing money.
In order to understand the problems with low deposit mortgages, there’s a few things you need to know. There’s a complex interplay between the housing market, government regulations, and commercial lenders.
The NZ Government
The government of NZ has a few tools at their disposal to try and help keep the economy stable. The OCR (official cash rate), LSAP (Large Scale Asset Purchasing Programme), Term Lending Programme, and the LVR (Loan to Value Restrictions).
The OCR is the interest rate set by the Reserve Bank. It influences what the banks base their lending rates on. You’ll see the OCR drop when the economy needs stimulating, such as after COVID19 or the global financial crisis. This encourages the banks to drop their interest rates and boosts the housing market.
The other important figure in the housing market is the LVR. This is a limit on how much a bank can lend based on the amount of the deposit. It’s a figure that takes into account if the housing market is booming, and how healthy the economy is. It’s a fine balance, to ensure the housing market is stable, and home buyers can buy without risking a low deposit lending.
The major risk of low deposit lending is largely what caused America to slide into a recession in the global financial crisis. Banks loaned people 95% of the home’s value, with 5% (or less) house deposits, in a great economy and a housing bubble propping things up. Then, the economy slowed, house prices started falling, and suddenly there were a huge number of people with a sub-prime mortgage. This is when more is owed on the home than the property is worth. This led to defaults, huge reductions in household spending, and mortgagee sales. While these sub-prime mortgages were only part of the cause of the financial collapse, it was a factor that could have been avoided with better governance.
Mortgages and banks in NZ
For banks, there are two major opposing factors in granting a mortgage. The first is that they want to make money. They are a business. They need to give as many mortgages as possible in order to make money. But they also need to manage or eradicate risk, so they are on the lookout for low risk loans, with large deposits, where they know they aren’t risking their money. But if they only loaned to people with a 50% deposit and an $200k income, they’d never make money.
As well as these factors, they are governed by the LVR; this is one of the major ways that the NZ government can avoid what happened in the USA.
Currently in NZ, the RBNZ has removed all LVR restrictions, so banks are making decisions based on their own criteria. Mortgage providers range from a tempting 5% deposit, through to 20% minimum.
What does this mean for you when you’re buying your home?
If you’re looking at buying a home, you need to be aware of this complex interplay of factors. It’s not just crystal ball gazing and trying to decide if interest rates are going to rise or fall and if you should fix your interest rates for five years. It’s about the deposit you have, and why it could be dangerous if you have a small deposit.
The risks of a small deposit
There are a number of risks with a small deposit that may mean it’s worth saving for a bit longer to get into your new home.
Higher interest rates
The lower your deposit, the higher the interest rate you’ll be charged to counteract that risk the bank is taking with you. This increases those mortgage repayment rates, means you’ll be paying significantly more interest on your home overall, and if there was a change to your income, you’re far less likely to be able to restructure your mortgage or manage a shortfall.
A sub-prime mortgage
While the NZ housing market has been growing for many years, the NZ economy is a small cork, bobbing on the ocean of the world economy. The effects of COVID19 on the world are unknown yet- and even if there wasn’t a pandemic, the international economy can change quickly in response to a number of external factors.
If something catastrophic happened, and your home was suddenly worth less than the mortgage, there’s no escape. You can’t sell the house and recoup your losses; you’re stuck.
No wiggle room
Situations change for individuals. People get sick or die or lose their jobs. Spouses split up. Unexpected expenses crop up. Earthquakes happen. If you buy a home on a low deposit, there’s very little breathing room until a substantial chunk of mortgage is paid off. You’ll be paying off more mortgage a month, with less surplus for household expenses. What happens if the hot water tank needs replacement, or one of the kids gets sick and needs a full time carer?
This is where the Millennial Americans are struggling; a low deposit means big mortgage repayments. And for some, this is crippling their financial freedom and choices they can make about their lives.
Low deposit mortgages are a risk you can take
For some people, the risk in a low deposit mortgage is worth it. The money saved on rent, gambling on low interest rates paying off, and paying off that mortgage as aggressively as possible works for them.
But, for some people, it leaves them open to financial distress and the risk of losing everything. If you’re saving up for a deposit, it can seem like a painfully slow task. It could be tempting to take the 5% deposit and run. But first, you need to understand the risks and benefits, and try and protect yourself from risk as much as possible.
Speaking to a financial advisor gives you guidance and the benefit of years of experience. Your advisor can walk through both scenarios and help you to make an educated, low-risk decision that means your new home is an asset that will be with you and support you in your long term goals. Contact Sam Kodi today if you’re thinking about a new home, and find out if a low deposit mortgage is the right decision for you.