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What is a mortgage but money rented from a bank?

Posted By The Investor On In Updated,Property | 62 Comments

Can you believe it? My own sister uttering the dreaded words:

“I am just throwing money away by renting.”

Ouch! That’s up there with “renting [1] is dead money”.

She might as well have added, “You Only Live Once!” and then spent her ISA savings on a YOLO [2] tattoo.

Before we begin: I’ve learned that it’s impossible to write about UK property without provoking an outburst of emotion – from every faction – so a quick nod to the laundry list:

But that is not what I’m talking about today.

What I’m questioning is the idea that renting [7] is inherently wasteful and that having a mortgage is inherently productive.

Let’s unpack this to see why my sister has compounded the damage she did by watching The Water Babies on VHS 20,000 times and then crying and claiming I hit her when I tried to make it stop.

Renting is: paying for something valuable

First off, renting is nothing like throwing money away.

When you throw money away, then – unless you’re Robin Hood, Brewster [8], or in fear of St. Peter – you get nothing back.

In contrast, when you give money to your landlord, you get somewhere to sleep, eat, make whoopee, and write investing blogs.

Here is Maslow’s famous hierarchy of needs:

Maslow's Heirarchy of Needs [9]

Hint: the big ones are at the bottom. (Click to enlarge)

Maslow rightly understood that ‘shelter’ was crucial to human beings. We tend to freeze, rot, dry out, get eaten by animals, or are plagued by packs of foreign exchange students without it.

In fact, Maslow stated shelter was as important as sex, food, and air – but maybe not in that order.

(In the modern world, you don’t get much sex without shelter. Although to be fair you will then get more than your fair share of air.)

Housing, in short, is a basic human need. This is what your landlord gives you in exchange for rent. An essential of life! Maybe my sister should send her landlord a thank you card, rather than a dismissal?

But what about home ownership? Is that essential?

Sadly, Maslow didn’t tell us where “ability to hammer a nail into own wall’ or “opportunity to take part in house price bragging” fitted into his pyramid. He lived in simpler times.

My hunch is – daytime property porn be damned – that Maslow would consider such things to be self-actualization, topping the pyramid alongside philosophy, ballet, and drinking mint juleps.

What is a mortgage in legal terms?

A mortgage is a loan used to buy property. It’s an agreement between you and a lender that involves the latter loaning you the money you need to buy a property (or else a way of raising money against the value of a property you already own).

When you take out a mortgage, you agree with your lender to pay it back the capital you borrow – plus any interest accrued – over some prearranged period of time – typically 25 years – and at an agreed interest rate.

The interest rate you’re charged may vary with market rates (a so-called variable rate mortgage) or more commonly be fixed for some years.

In the UK, fixed-rate mortgages typically run for two to five years. After that period you’ll go onto the lender’s variable rate mortgage, unless you take out a new fixed-rate deal.

Other types of mortgages are available. For instance, a discount mortgage varies with your lenders’ variable rate. But a discount is applied so you pay a little less.

Note that in the UK1 [10] interest rates will fluctuate over the lifetime of your mortgage.

This means that when any fixed-rate mortgage or other deals expire – or on an even more regular basis with a variable rate mortgage – your borrowing costs will be recalculated. Hence your monthly payments will vary.

When do you clear the mortgage?

Most home buyers take out a repayment mortgage. Here the total borrowing cost – including interest – is calculated at the start of the arrangement. You steadily pay the interest and repay the principle via a schedule of monthly payments.

Interest-only mortgages are also available. These are particular popular when buying investment properties [11]. With an interest-only mortgage you only pay the interest over the term of the mortgage. You pledge to repay all the capital at the end of the term (say 25 years).

Most repayment and interest-only mortgage agreements do allow you to make payments in excess of what was initially agreed, however. These extra payments can dramatically reduce how long it takes you to fully pay off the loan, and hence the total cost of borrowing.

Play with our mortgage calculator [12] to see how you can reduce the cost of your mortgage. (It’s as close as it comes to getting exciting about a mortgage.)

Finally and crucially, note that a mortgage is a secured loan. It is backed by the value of the property you buy with it.

Putting up your home as collateral like this makes a mortgage much less costly than other personal loans. But the quid pro quo is that the mortgage agreement gives the lender the right to seize your property if you fail to keep up with your payments.

A mortgage is money rented off a bank

So far, so conventional. You take out a mortgage to buy a property in exchange for a monthly bill – and the risk of losing your home if you don’t keep up with your payment schedule.

However I believe it’s helpful to think a bit deeper about what a mortgage really is. Like this we can exorcise some of the dogma of home buying.

Because despite that aforementioned fabulous need-solving you achieve by renting, most people still aspire to swap paying the monthly rent for a new life as a mortgage-shackled wage slave.

Even I did the deed [13] eventually.

And there’s nothing wrong with that. Buying their own home is the best investment [14] most people ever make.

However there’s nothing magical about a mortgage.

And it certainly isn’t free.

Rentaghost in the machine

When you buy a house [15] with a mortgage, the bank gives you money, as discussed.

Let’s say it gives you £200,000.

Party time! (I’m assuming hedonism for you is 30 days and nights on Rightmove.)

Once the initial euphoria of home hunting is over, a new mortgage owner begins the slog of paying the darn thing off.

And it turns out – obviously – that the bank didn’t give you £200,000 for nothing. As we’ve discussed it wants interest on the mortgage.

It’s as if it leased you the money. You’re paying to rent the money off the bank.

You have swapped rent payments to your landlord for rent payments to your bank.

Note again that if you only ever pay your ‘money rent’ and nothing else, then you must give back the £200,000 borrowed at the end of the mortgage term.

Just like you have to hand back a rented house to your landlord!

To avoid this – and to keep your home – then you must repay the capital also.

Effectively, with a repayment mortgage you’re buying £200,000 in cash off the bank, in monthly installments.

You might even think of a mortgage as a cash savings account [16] that starts £200,000 in the red. With a repayment mortgage, you’re salting away £350 a month. After 25 years, the balance is £0.

Happy days!

Equally, if you can rent your home for less [17] than you’d pay to buy, then you could choose to save the difference. You might even save up £200,000 that way.

Note: I’ve oversimplified here. As already flagged up, monthly repayments are in reality variable over the mortgage term as they fluctuate in some fashion with interest rates.2 [18] Capital payments are a smaller share of the monthly bill at the start but predominate at the end, as your previous repayments reduce the interest due. Again, check out the graphs via the Monevator mortgage calculator [19].

Only money under a mattress is dead money

Of course no bank these days will lease you £200,000 without some security.

The bank tries to protect itself twice.

Firstly it demands a deposit of at least 5%, but frequently much more.

Secondly there’s that inconvenient fact that it can repossess your house should you fail to repay the money you borrowed (/rented) off it.

Let’s say my sister has had enough of ‘throwing money away’ and wants to buy a flat for £500,000.

She’ll likely need at least £25,000 as a deposit – and I’d strongly urge her to aim for £50,000 or more [3] – in order to appease the bank’s money landlord.

Of course, you have to give a deposit to a property landlord to rent their house, too.

But when I last rented a place, I put down one month’s rent – or only about 0.25% of that property’s market value at the time. Bargain!

The opportunity cost of a mortgage deposit

As interest rates on cash [20] have recovered, the situation has become even starker. Today, my sister’s would-be deposit cash is only dead money if she keeps her savings under a mattress.

I can think of little worse than looking under my sister’s mattress, but I’m sure there’s no money under there.

Instead, my sister has her money in savings accounts, bonds, and the stock market [21].

Even if she simply puts her would-be house deposit cash into a super-safe fixed-rate savings account, she can currently earn 4% or more.

That’s hardly dead money.

By the same token, it’s not dead money if the cash is used to get a mortgage.

If you’re paying a mortgage rate of 5%, then your deposit is effectively in the equivalent of a savings account paying 5% interest, tax-free.

That’s nice, too.

Again, I am not saying one arrangement is inherently better or worse than the other. I am saying these decisions have more in common than you might think.

The deal when you pay rent

Buying a house basically involves:

Both private owners and landlords also get an income from leasing out their property.

As a home owner you get the better deal, since you rent it out to yourself [22], tax-free3 [23], whereas a landlord leases it to a third-party tenant who might not pay and who won’t clean the gutters. Worse, her rental income is liable for tax [24].

In contrast, as a rental tenant your landlord handles most of the faff for you.

Renting simply involves:

Whereas the deal for the landlord looks something like:

Your landlord also takes on risks on your behalf [28]. There’s the risk that house prices will go down for starters, as well as the risk that interest rates will go up.

Of course landlords do all this in expectations of making a profit over time. I expect house prices will rise [29] over 25 years, and rents too. But there’s no timetable – and it’s still a risk.

So a landlord deals with a lot of faff, takes risks, and satisfies a key human need.

That’s quite the deal you get for “throwing money away” by renting a home instead of buying.

You decide if it is a good time to rent money

Once more with feeling: none of this is to say that it’s not a good time to buy a property, or vice-versa, or to rent, or vice-versa.

When I wrote the first version of this article in 2013, house prices seemed very expensive to me, especially in London.

Luckily, I noted back then that I’d been wrong [30] about prices for a decade. And now another decade has passed and prices are even higher again! But they’re apparently wobbling…

So who knows.

What I was confident about, however, was that borrowing was cheap in 2013.

I wrote:

I do think it’s a good time to rent money.

With five-year fixes under 3%, a big cheap mortgage [31] looks a steal.

We saw money get even cheaper to rent for many years after that – as low as 1%!

The cost of money eventually did rise quite a bit in 2022, however, as the Bank of England hiked interest rates. Mortgage rates spiked further in October 2022 with the Mini Budget farrago [32].

But rates have since come down again. Indeed it’s interesting to see people (not me [4]!) predicting 40% price falls [33] when five-year fixes are available at 4%, given that ten years ago money already seemed very cheap with fixes not vastly lower at 3%.

Of course the difference today compared to 2013 is even-higher house prices.

Property prices have grown far faster than wages have increased, too.

Which way will you rent?

Sadly, banks will only rent money cheaply to most of us to buy homes, and homes seem expensive. There’s the rub.

But the point is: renting a home isn’t throwing away money. It’s paying for a service.

And a mortgage isn’t free. You pay to rent money.

It amuses me that the conventional thinkers who say renting is dead money are also often the same people who say paying off their mortgage [34] was the best feeling they ever had.

Make your mind up! Do you like renting money or not?

Note: Original article updated in February 2023, so comments below pondering what is a mortgage and/or the meaning of life may be out-of-date. On the other hand this stuff is pretty timeless. See you in 2033, across a rubble-strewn landscape and so on!

  1. Unlike the US where you typically lock in a mortgage rate for the entire term when you buy. [↩ [39]]
  2. Whereas, for example, dividing £200,000 by 25 years worth of monthly payments is £666 a month. [↩ [40]]
  3. It is called imputed rent [41]. Please don’t complain to me, follow the previous link if you want to learn more. [↩ [42]]
  4. The income-less gaps between tenants. [↩ [43]]
  5. The money stolen by tenants who don’t pay. [↩ [44]]