The Business Of

Banking | Barclays | Mortgages

Morning All!

TGIF! The weekend is so close! But before we get there, we’ve got one final newsletter to round off The Business Of Barclays. Let’s have a quick recap of some of the fun, surprising things we’ve learnt about the UK banking giant this week…

• A Real All-Rounder - Barclays isn’t only the 5th largest mortgage provider in the UK, they’re also the 7th largest investment bank in the world!

• Branches Are So 2000s - due of the rise of online banking, the number of Barclays branches has declined 77% since 2004 from 2,061 to just 481!

• Runs Aren’t Always Healthy - at SVB, a huge number of depositors wanted to withdraw their money. SVB didn’t have the cash on hand. SVB went bankrupt!

Okay so, today we’ve got a very special newsletter - we’re going to explore the world of mortgages! On Tuesday we dove into net interest income (NII) and saw that a huge chunk of Barclays loans (£399bn) were in the form of mortgages (£174bn).

Well today, we’re going to look at how Barclays actually make money from those mortgage loans. Fair warning - there’s a few more numbers involved… but for those who can stick it out to the end, I think there’s a lot to learn today! So, without further ado, let’s get stuck in!

Bob Buy A House In London…

Okay, so first thing’s first. We’re going to use an example throughout today. And the example is going to be a chap called Bob looking for a house in London. Very imaginative from me I know! But anyway, after doing his research, Bob finds that the average house price in London is ~£528k, so he goes on Rightmove and finds the house (pictured below) in South London for £500k. Happy days!

But there’s a problem! Like most people, Bob doesn’t have the full £500k in his bank account. And so what does Bob need to do? He needs to get a loan (mortgage) from his bank (Barclays)! Now, in order to get a mortgage, Bob will have to put down some kind of deposit. The minimum deposit required in the UK is usually ~10% of the value of the house - and then the bank will provide the remaining 90% as a loan. And this 90% figure is referred to as the loan to value ratio.

But here’s a question, what’s the average loan to value ratio at Barclays? Well, in 2022 it was 68%. Which means that on average, for a house worth £500k, the buyer would put down a deposit of £160k (32% of £500k) and Barclays would provide a loan of £340k (68% of £500k). So, let’s use those numbers for our example too!

Now, final thing to set up in our example - how long does Bob want to take this loan out for? Well, the average mortgage term in the UK is ~25 years. So, we’ll also use 25 years. And with that, we’re ready to crack on!

Hold On, Why Do I Pay Interest Again?

Okay, so to really understand what’s about to come. We’re going to first start by asking ourselves the question - what would Bob’s monthly mortgage repayments look like if Barclays didn’t charge him any interest on his £340k loan? Let’s quickly work that out. So, £340k over 25 years is £13,600 per year. Which works out to ~£1,133 per month. But obviously, if Bob just pays that amount to Barclays, how much revenue has the bank made? Nothing! Because Barclays has given Bob £340k and Bob’s given them back £340k after 25 years. The bank doesn’t benefit at all!

In fact, the bank would actually lose money. Because remember, Barclays can only give Bob the £340k loan in the first place because of the deposits the bank has been given… for which they’re paying an interest rate on! Now on Tuesday we saw Barclays were paying ~0.7% on their deposits in 2022, so, let’s assume Barclays are paying 0.7% interest annually on that £340k. That would be an INTEREST EXPENSE of £2,380 per year. And £59,500 over 25 years! So, that’s clear. Barclays absolutely has to charge Bob interest on his loan so they don’t make a loss!

Now, in order to find out Barclays’ INTEREST INCOME, the next thing we need to find is – what’s the interest rate? What kind of interest rate would Bob have to pay on their £340k loan? Well, the screenshot below (from Barclays’ website) gives us some figures.

And what we can see is that for all three of those mortgage products, the ‘fixed rate’ is either 5.07% or 5.10%.

Now for our example, we’re going to keep it nice and round at a 5% fixed rate. But we’re actually going to fix Bob’s mortgage for 25 years. This is slightly unusual these days and we’ll come onto variable rates later in the newsletter. But to keep things simple, we’re going to go for a 25-year fixed mortgage!

Alrighty, let’s crack on with some numbers!

Interest Expense = £59k, Interest Income = £256k, NII = £197k!

Okay, so we’ve got our building blocks ready. £340k loan. Paid off over 25 years. Annual interest rate is 5% - fixed for 25 years. Now, how much will Bob actually be paying back every month? And how much do Barclays record as INTEREST INCOME every year?

Well, in order to work out how much Bob pays Barclays every month, we need to use this scary-looking formula below. In reality, it’s not actually that scary - all we need to do is plug in ‘P’, ‘r’ and ‘n’ and voila – we’ll have the amount that Bob needs to pay Barclays every month for the next 25 years!

Okay, so if we plug in £340k for P, 300 for n and 0.0042 for r, what we get is a monthly payment of £1,988. £1,988 x 12 months = £23,851. £23,851 x 25 years = £596,282. So over the course of our mortgage term, Bob will pay Barclays ~£596k.

And given the loan was £340k, it means that Bob will have paid a total interest amount of ~£256k over those 25 years. In other words, Barclays will make INTEREST INCOME of ~£256k over 25 years. Which seems pretty tidy given the interest expense we calculated earlier was ~£59k. But here’s a question – how do Barclays record this income? Do they say interest income is ~£10k per year (£256k divided by 25) for the next 25 years? Well, not quite! And that’s what we’ll start to wrap up with now!

Interest = Revenue, Principal = Not Revenue

Okay, so we’ve worked out that Bob will pay £1,988 every month for the next 25 years (£596k in total). And that’s great, because that’s the side of things that we look at as mortgage purchasers. But there’s another side - and that’s how Barclays look at things!

Now, the first thing to note is that these £1,988 monthly repayments are actually made up of 2 types of payments. One, the principal repayment (£340k over 25 years). And two, the interest payments (£256k over 25 years). This sounds obvious, but the reason it’s a bit odd is because, Ross whilst only makes one monthly payment (£1,988). The principal repayment and the interest payment are recorded in different ways by Barclays. What do I mean?

Well, to keep it simple, the ‘principal’ part of the mortgage repayment isn’t considered as revenue by Barclays. It’s only the ‘interest’ part that’s considered as revenue! And this is why we looked through that no-interest scenario. When Bob paid Barclays no interest on the loan, Barclays didn’t make any revenue. Bob’s mortgage repayments were just paying down the principal (the initial mortgage loan) and Barclays would reduce the loan amount in their balance sheet. But there’s no impact on the income statement.

However, when interest is thrown in, there is an impact on the income statement. Because that interest isn’t paying down the principal amount… it’s additional revenue that Barclays make! And as we now know - this revenue is called interest income.

Now – I imagine some of you might be wondering – how do we fill in the £xx’s? How on Earth are we supposed to know how much of that £1,988 repayment is ‘interest’ vs ‘principal’?! Well, we’re going to uncover that now and let’s start off with the very first payment in month 1.

The outstanding mortgage balance is £340k (because it’s the first month). We know Bob pays £1,988 every month. Now, the interest part of that is calculated as below. Remember 0.42% = 5% divided by 12.

And in the table below we can see this £1,417 interest repayment highlighted with the red circle. The remainder of the £1,988 payment by Bob is noted as the principal repayment - £571 - highlighted in green.

Okay, so what about month 2? Why are the interest and principal repayments different? Well because the outstanding mortgage balance is now different from £340k. It’s now £339,429 (because you take the principal repayment in month 1 away from the outstanding mortgage balance in month 1)!

And this goes on and on, month after month, throughout the mortgage term! The table below shows us what the interest and principal payments look like halfway through the term in month 150 (12.5 years in).

We can see that the total monthly payment is still completely constant at £1,988 (because it’s a fixed rate mortgage). The outstanding mortgage balance continues to decline (down to £220k). And we can see that principal payments are now larger than interest payments. Because remember, the interest part falls as the outstanding mortgage balance falls.

And these final few rows below really highlight that. Interest payments are next to nothing in the final few months of the 25-year mortgage term because of how low the outstanding mortgage balance is towards the end of the 300 month period!

There’s lots of interesting articles about this and what this means for people thinking about home equity values, etc. I recommend giving this article a read if you are interested! But for now, let’s get back to what this means for Barclays and NII!

Finally - We Now Know Barclays’ NII In Each Year!

Okay, so let’s bring it all together. We’ve seen how Bob’s monthly mortgage payments are split between ‘interest’ payments and ‘principal’ payments. And we’ve seen that interest payments (and hence Barclays’ interest income) are much higher earlier on in the mortgage term.

The chart below shows us how the mortgage schedule looks like on an annual basis. We can see at the bottom that the total interest figure shows £256,282 – that’s what we already calculated earlier as being their total interest income from this mortgage loan. But now we know what NII (revenue) Barclays will record in each year!

So, year 1: Barclays interest income = £16,841. Barclays interest expense = £2,380 (the £340k x 0.7% we saw earlier). And so Barclays would make a Net Interest Income (NII) of £14,461 in Year 1.

And that is that! If you’ve made it to here – great job! I think that’s some pretty solid work we’ve just gone through. And some pretty complex stuff. Don’t worry if you don’t understand all of that straight away - it might take a bit of time. But I hope that’s going to be helpful in your future understanding of banks, loans, mortgages, etc!

Mortgage Meltdown!

Okay, very last thing. And I’m not really going to go into any detail whatsoever on this because it’s a Friday and this newsletter is getting too long! But I can’t write about mortgages without mentioning the current mortgage crisis in the UK.

So, in a few sentences, what’s the issue? Well, above, we’ve been calculating mortgage monthly repayments based on a 25-year fixed interest rate. Our man Bob knows exactly what he’s going to pay every month (£1,988) for the next 25 years.

However, this isn’t often the case. Normally, people will get mortgages with the first 1-10 years on a fixed interest rate. But after that, the interest rate they pay will become VARIABLE. And guess when that’s a problem? When interest rates are going up. And what have we seen this week – interest rates have been going up over the last 2 years!

I’ll leave it there. But these YouTube videos (here and here) give a nice, clear, simple explanation of what’s going on in the UK mortgage market!

10th Nov 2023

Nigel Jacob CFA