Matteo Benetton, Philippe Bracke, João F Cocco and Nicola Garbarino
Academics have made the case for mortgage products with equity features, so that gains and losses due to fluctuations in house values are shared between the household and an outside investor. In theory, the equity component expands the set of affordable properties, without increasing household debt, and default risk. These products have not become mainstream, but in a recent paper, we study a large UK experiment with equity-based housing finance — the Help To Buy Equity Loan scheme. We find that equity loans are mainly used to overcome credit constraints, rather than to reduce investment risk. Unconstrained household prefer mortgage debt over equity loans, suggesting optimism about house price risk. Equity loans could still contribute to house price inflation: we don’t find evidence that houses purchased with equity loans are overpriced, but an assessment of the aggregate effects is beyond the scope of the paper.
The economic rationale for equity loans
Mortgage-financed house purchases create a levered position in real estate that amplifies the effects of house price fluctuations on the household’s net worth (Campbell and Cocco (2003)). These risks are correlated across households and have aggregate consequences, as evident during the Great Recession. Under traditional mortgages, households bear almost all house price risk, and the only risk-sharing mechanism is defaulting. Academics, most notably Shiller (1994), have proposed alternative financing structures that make the payoffs to investors who provide financing contingent on future house values. As house price risk is shared between households and investors, both the amount of vanilla debt and default probabilities are reduced.
The Help-To-Buy Equity Loan scheme
In spite of their large potential benefits, these hybrid products, with debt and equity features, have not become mainstream. An important exception is the recent Help-to-Buy Equity Loan (EL) scheme introduced by the UK government in April 2013. The EL scheme provides capital of up to 20% (40% in London since February 2016) of the property purchase price in exchange for the same share of its future value. The scheme is limited to new properties with a value below £600,000. To qualify, households have to provide a 5% down payment, and there are no restrictions in terms of age, income or wealth (but EL cannot be used to purchase a second home). As the name indicates, the scheme was motivated by affordability, rather than risk-sharing, considerations. From the scheme’s inception until end of June 2018, the total value of the equity provided by the UK government was £9.9 billion for the acquisition of properties with a total value of £46.5 billion.
In this paper we study the reasons behind the large demand for ELs. Homebuyers can use ELs as an alternative to traditional mortgage financing, in order to reduce their leverage and exposure to house price shocks (the risk-sharing motivation studied by academics). But ELs can also be used in addition to a traditional mortgage, in order to overcome credit constraints and purchase more expensive properties (the affordability issues that motivated the launch of the scheme).
The role of credit constraints
To understand the role of credit constraints, we study the distribution of origination loan-to-value (LTV) and loan-to-income (LTI) ratios for eligible property transactions between 2013 and 2017. Lenders use LTV and LTI ratios to determine the maximum loan amount and as cut-off criteria above which they reject mortgage applications, but the EL is not included in their calculations. We show that an overwhelming proportion of borrowers would not have, without the EL or a larger down payment, been able to borrow the mortgage amount needed to purchase their property. As a benchmark, in Panel A of Figure 1 we plot the distribution for borrowers who were eligible for the EL scheme (ie bought a new property under £600,000 after 2013) but chose not to use it. Very few mortgages have LTV above 90% and none has LTV above 95%. Very few mortgages are above the 4.5 LTI cut-off. In Panel B we report the distributions for EL borrowers, and, in addition to LTV and LTI ratios calculated using the mortgage debt, we plot cumulative LTV (CLTV) and LTI (CLTI). The majority of EL borrowers take out a mortgage with 75% LTV, which allows them to purchase the property with the maximum equity loan (20%) and the minimum down payment (5%). The corresponding CLTV is 95%. Compared to non-EL borrowers, the LTI distribution of EL borrowers is shifted to the right and bunched towards the 4.5 LTI threshold. The corresponding CLTI distribution shows that many EL borrowers are over the 4.5 limit.
Figure 1: Loan-to-value and loan-to-income distributions (new properties with value below £600,000, April 2013-March 2017)
EL borrowers also take mortgages with longer maturities, which relaxes payment-to-income constraints. They are significantly younger, much more likely to be first-time buyers, and they use a significantly lower down payment than those who buy properties just above the threshold.
The London experiment
To provide causal evidence on how borrowers react to the availability of equity financing, we exploit a change that took place in February 2016, when the maximum EL contribution for the acquisition of properties in London increased from 20% to 40% of their price. We use a difference-in-difference methodology to show that a large number of individuals took advantage of the increased scheme contribution to buy more expensive properties, instead of reducing their mortgage debt and house price risk exposure. The properties are more expensive because they are better quality (eg more square meters) rather than overpriced — the results are very similar when we into account local house price inflation. This is again evidence of the role that credit constraints have in the scheme take-up.
House price expectations
In spite of its success, a large number of homebuyers who could have taken advantage of the EL scheme and of the government subsidy that it involves, have not done so. Why not? Homebuyers who have not used the EL scheme could have bought the same house using the EL and a 20% lower LTV mortgage. Their mortgage payments would have been lower due to both the lower mortgage amount and the fact that a mortgage with a 20% lower LTV has a lower interest rate. For borrowers with an original mortgage LTV over 85% the reduction in monthly (median) mortgage payments would have been substantial: from £823 in the base case to £528.
On the other hand homebuyers would have had to give 20% of the future value of the house to the government at EL termination. We calculate the minimum (break-even) rate of expected house price appreciation that a risk neutral individual, or one that ignores house price risk, requires to be better off without the EL. Our calculations show that for individuals who did not make use of the scheme and took a mortgage with an LTV greater than 85%, the average break-even rate of annual house price appreciation is as high as 7.7%. The choices not to use EL can therefore be rationalized by a high expected rate of house price appreciation. (We assume that house buyers are risk-neutral, but risk-averse individuals should require an even higher return on their investment). Alternatively, one may interpret the high implied house price expectations as a proxy for informational or cognitive frictions that affect households’ awareness and evaluation of the scheme.
Conclusions
We provide evidence that the main driver of the large demand for ELs in the UK comes from a desire to overcome credit constraints, and increase housing consumption. Our data cover a period of fast house price appreciation (which is when affordability problems become more acute) and households may behave differently when prices decline. Any macroeconomic benefits from these products will also depend on their effect on house prices, the risk for investors, and the risks faced by suppliers of equity loans — all issues that are outside the scope of this paper.
Matteo Benetton works at the Haas School of Business, University of California, Berkeley, Philippe Bracke works at the Financial Conduct Authority, João F Cocco works at the London Business School and Nicola Garbarino works in the Bank’s Prudential Policy Directorate.
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