30 years after – part 1

Posted: June 22, 2023 | Author: julesbirch | Filed under: Buy to let, Housing market, Mortgages |Leave a comment

Originally written as a column for Inside Housing.

Interest rates rising to tame inflation. Home owners worrying about how they will pay their mortgage. Politicians panicking about the economic and electoral impact.

Prospects for the housing market arguably look bleaker than at any time since the spectacular crash of the early 1990s (unless you are a renter waiting for prices to fall, of course).

Ultra-low interest rates helped the economy out of the downturn that followed the financial crisis in 2008 and have underpinned rising house prices over the last 13 years. But that whole era now seems to be over and the escape route looks blocked.

So how does the situation now compare to what happened 30 years ago? This first part of a two-part column looks at the similarities – and some significant differences.

Mortgage lending: Mortgage rates have now hit 6 per cent-plus. I first started writing about housing in the immediate aftermath of Black Wednesday in 1992 when interest rates briefly rose to 15 per cent.

So no reason to panic? Far from it: people borrowed far less back then to buy homes at much lower prices so the effect on household finances is just as bad.

There are two big differences. First, most borrowers in 1990 were on variable rates, meaning they felt the impact of rate rises immediately. Around 80 per cent of borrowers now are on fixed rates so they will only feel the impact when their term comes to an end but it will be much greater when they do.

Second, less than half of home owners (46 per cent) now have a mortgage compared to almost two thirds (63 per cent) in the early 1990s. Rate rises make no direct difference to those who own their home outright.

Combine those two factors and the impact of rising rates on inflation may be smaller and slower than the Bank of England hopes – but there two important caveats to that.

Inflation: The Bank is increasing interest rates to reduce inflation that remained stubbornly high at 8.7 per cent in figures published by the Office for National Statistics (ONS) on Wednesday. But surely rising prices for mortgages must themselves be inflationary so how does it square that circle?

The answer is that the Consumer Price Index (CPI) measure that is used in the inflation target given by the government to the Bank does not include owner-occupier housing costs. Arguably, this is a key reason why the impact of ultra-low rates on house prices has been ignored until now.

Under the ONS’s preferred measure of CPIH (H for housing), which includes rents as a proxy for owners’ housing costs, inflation is 7.9 per cent. However, for a measure that includes mortgage interest payments you have to go back to the one used in the 1990s, the now discontinued Retail Prices Index (RPI). Using that, inflation is running at 11.3 per cent. 

Buy to let: The second caveat is that the figures above do not include around two million mortgages held by landlords. That means the impact of rising rates will be felt not just by landlords but also potentially by the tenants who pay their mortgages for them.

I don’t remember many landlords passing on their gains when interest rates fell to record lows after 2008 but they seem more than happy to claim they have no choice but to raise their rents now. It remains to be seen whether they will succeed but the impact of higher mortgage rates could be felt not just by seven million owners with mortgages but also by 4.6 million private renters (and two million landlords, who may also have a conventional mortgage themselves). Take all that into account, and a greater proportion of households could be impacted than in 1990. 

Prices: House prices have just begun to fall, according to the Nationwide, making 2023 the equivalent of 1990 in that crash, when prices were in negative territory for the next three years and flat for three years after that. Between one and two million borrowers who had bought at higher prices were in negative equity.

Back in 2023, Capital Economics estimates that if 6 per cent mortgage rates last for several years house prices could fall by around 25 per cent, which really would feel like a 1990s re-run. But it says it’s more likely that inflation will decline enough to allow interest rates to be cut by mid-2024, limiting the reduction in house prices to 12 per cent.

What about in real terms, though? According to the Nationwide, nominal house prices rose 4.8 per cent in 2022 but fell 3.1 per cent in the year to March 2023. In real terms (using RPI inflation) the average UK house price peaked at £295,975 in the first quarter of 2022. In the first quarter of 2023 it was £258,115. That means that, masked by higher inflation, prices have already fallen by 13 per cent in real terms.

Affordability: Home owners with a mortgage should in theory go into this downturn much better protected than they were in 1990 or 2007. Rules introduced in the wake of the financial crisis mean lenders had to stress test whether borrowers could still afford mortgages at three percentage points higher than their standard variable rate. That means rates of around 7 per cent so they should be able to afford the current increases.

So what’s the problem? First, the Bank of England stopped stress testing last year to make it easier for first-time buyers to borrow more. Other controls should have prevented the free-for-all we saw up to 2007 but it still looks like a spectacularly ill-timed move.

Second, we don’t know what banks took into account in their affordability tests. Not soaring energy prices and food bills, that’s for sure – but did they consider the impact of changing circumstances such as having children or relationship breakdown that would restrict incomes and increase other costs?

The impacts will also be greater on mortgage prisoners, people already stuck on higher rates, many of them since the financial crisis. These may now include victims of the cladding scandal.

The Institute for Fiscal Studies estimates that people with a mortgage will see their average disposable income fall by 8.3 per cent as a result of the rate rises. However, the most vulnerable 1.4 million people, half of them under 40, will see a 20 per cent drop in the disposable income – and that is before any further increases in rates.

Figures like that suggest there is zero room for complacency about the situation. In part two of this column I’ll be looking at the wider consequences and what the government can and should be doing to help.

---