Why Mortgage Rates Are 3% in Europe and 18% in Kazakhstan
Translated from Russian with the help of AI. Original: Russian version
I break down the components of a mortgage rate in Kazakhstan — funding cost, cost of risk and the bank's margin — and argue that lowering the rate means reducing each of them: fighting inflation, speeding up collateral recovery, and fostering competition among banks.
Before all the recent events, I ran a poll on the topic of this post, but the events in Ukraine knocked my focus off course and I had to postpone the question. I have finally decided to explain the rate in plain language.
A loan rate, mortgages included, consists of the following components:
The bank's cost of funding. Mortgage programs are funded mainly by individuals' deposits and by bonds issued by second-tier banks. Ideally, funding should come from bonds. Banks currently raise funds at an average of 12-13% following the increase in the base rate. Previously, the average cost of funds was around 10-11%.
The cost of risk on the borrower. If a borrower becomes problematic and does not repay the debt, all losses on that borrower are shifted into the cost of risk and included in the rate. In other words, good borrowers always pay for bad ones. Not all borrowers can be perfect, and the higher a bank's risk appetite, the more bad borrowers it ends up with and the higher the cost of risk it builds in. But there is another component here as well. To a large extent, the cost of risk depends on the regulatory process for recovering problem debt and selling collateral. At present, recovering collateral and selling it takes 3 years on average. For 2.5 of those 3 years, the borrower pays no interest. With a funding cost of 13% (and the bank pays this to those from whom it took the money), the loss comes to 37%. The bank must cover all of these losses from the sale, but as a rule, an apartment taken back from the borrower turns from a renovated apartment into a bare-shell one and sells for 30-40% less than its initial valuation. All these losses then go into the calculation of the cost of risk. It is all calculated mathematically. And if the collateral does not cover potential losses based on the history of collateral sales, banks set aside provisions — in other words, they recognize potential losses as soon as the borrower becomes problematic.
The bank's margin. As a commercial organization, the bank builds in its own margin, which must cover all fixed costs and provide the bank with a required rate of return. Currently the bank's margin is set at around 4% or higher, depending on competition and how unique the product is.
Therefore, to reduce the cost of mortgages for borrowers, each of these components has to be reduced.
The cost of funding can be reduced only by lowering the risk-free funding rate, which depends on the base rate. The base rate depends on inflation in the country. Inflation depends on economic policy as a whole. So if we want to bring down the overall cost of funding, we need to fight inflation. I have already written many posts about inflation. In essence, we need to increase supply in the country, stop stimulating imports through ill-conceived government programs, avoid stimulating consumer demand without expanding supply, and create an institutional environment that attracts investment. So if we want cheap mortgages, we fight inflation. Funding at non-market rates will only make apartments more expensive, and globally most people will not end up paying less on their mortgages.
Reducing risk must proceed in two directions. First, banks need to be given more data so they can analyze clients and improve their scoring models. Second, the cost of recovering problem debt must come down. This requires changing the laws on debt recovery as a whole, removing barriers to recovery, and establishing uniform law enforcement practice. One could write many posts about this alone. We should remember that good borrowers outnumber bad ones, and it is precisely the good borrowers who pay for the bad ones through the interest rate. For those who genuinely need help, the state should create support mechanisms. Instead of subsidizing rates, it is better to build the right mechanisms of assistance. We need a proper personal bankruptcy law — truly proper — one that solves the problems of everyone who genuinely cannot pay, rather than becoming a legal way of walking away from obligations.
The bank's margin is reduced by lowering the cost of running the process, in other words, by promoting the digitalization of second-tier banks. But most importantly, margins fall in a competitive market. The more banks there are, the lower the margin. Unfortunately, in our country the number of banks is only shrinking.
There are no other ways to reduce the cost of mortgages. The cost can be lowered artificially, as is happening now, but all of this simply gets passed through into real estate prices.