In your interest: Paul Clitheroe

Recently I was driving to Sydney airport. It was peak hour on the Sydney Harbour bridge, so I was crawling along, absent-mindedly listening to the radio. I had been following a bus and while I was aware it had a big advertisement on the back of it, I had not taken any notice until we came to a complete halt and the ad was about a metre away.

The ad had a massive “9%” return on it. This jolted me out of my semi-comatose state, in particular as it had “first mortgage lending” in big letters right above the “9%”. Like many other Money readers, I would love to get a secure 9% on my money. And we get what a first mortgage is all about. It sounds and feels very much like the experience that most of us have now, may do in the future or have had in the past. We own a home, worth say $500,000, and we have a mortgage on the property secured by a first mortgage to the bank, say $400,000.

The bank is very happy with a deal like this. It has made a loan of $400,000 secured by the $500,000 property. Of course, it will independently check that the property is really worth $500,000 and will get a conservative valuation. So if things go wrong and it needs to get its money back, even if the property value fell by 20% it is still covered. As an aside, if you did not have a 20% deposit, it would make you pay for mortgage insurance. So if it had to sell you up and did not recover all its money, the insurer would compensate the bank.

Of course, it would only lend you the money if you had a solid job and decent employment history to ensure you could meet the repayments even if interest rates go up. Sounds like a pretty secure deal for the bank, doesn’t it? But to make it even more secure, it is a “non-recourse” loan. This means that even if you lose your job, can’t make the repayments, your home falls in value by more than 20%, the bank sells your home and does not get its entire $400,000 back, plus any interest outstanding, as the loan is non-recourse it can take action against you to meet any shortfall.

No wonder we see a first mortgage as a safe investment for the bank. But in return for all this security that we provide, the bank charges us a pretty reasonable rate of interest. Right now that is likely to be around 4.5%-5%. In return, the bank pays savers anywhere from zero to about 3%. We all understand this: the margin represents the bank’s profit.

My apologies for being so simplistic, but stick with me. This is where investors lose the plot. Clearly, we would all like a secure 9%. But anyone offering us 9% will want a profit, so I imagine they will need to lend the money at a 2% margin, meaning the borrower will have to pay 11%. So, given any of us can borrow, on a first mortgage, with a decent property and a job, at around 5% or less, who is borrowing at 11%?

The answer is, of course, people who don’t have good security or a solid income stream. Or it could be a high-risk property development. Sure, this might be secured by a first mortgage but it is ridiculous to assume that any individual or a hard-nosed property developer is going to pay double-digit interest rates just for the fun of it.

Yet for my 37 years working in the world of money, I see perfectly sensible people signing up for ridiculous rates of interest, based on “first mortgage security” when they must know it makes absolutely no sense for their low-risk money. What really saddens me is that it is often retirees simply seeking a better income. So often, though, the investment collapses, leaving them with no income and no capital. Recently, we saw the collapse of Fincorp, Westpoint, Banksia and so on. Billions of dollars of investors’ money was lost.

Look, feel free to chase 9% or more via a loan secured by a mortgage, but go in with your eyes wide open. We all know full well that anyone paying around 11% so we can earn 9% is going to have about as much security as a paper tissue in a hurricane. These super-high-risk investments can work if everything goes well. But the slightest blip in the economy or in the development project and I can say with confidence you won’t see your income or capital again.