Policy overhaul required to help insulate Britain’s heavily-indebted households from rising interest rates

Dealing with the household debt hangover must be priority for next Parliament as the end of ‘holiday period’ for borrowing costs draws nearer           

A comprehensive plan to help tightly-stretched households manage the transition back to a world of more normal interest rates is laid out today in a wide-ranging report from independent think tank the Resolution Foundation.

The far-reaching report examines the effects that interest rate rises could have on indebted households over the medium-term, concluding that the number of highly geared households spending more than a third of their post-tax income on servicing their debt could more than double from its present 1 million to around 2.3 million by 2018. The market expects rates to climb to almost 3 per cent over this period.

A rise in the cost of borrowing will spell the end of a “holiday period” for many mortgagors who have been able to take advantage of rock-bottom interest rates of 0.5 per cent for the past five years – unprecedented in modern times.

The Resolution Foundation report says that the country needs shaking from its complacency about the implications of this return to a world of more normal interest rates, particularly for a minority of highly-exposed borrowers. But the report argues that careful action now, while interest rates remain low, can avert or mitigate the worst of the fall-out for households and the wider economy.

The scale of the UK’s household debt is considerable – £1.6 trillion (or 142 per cent of household income) which is projected to rise to £2.2 trillion by 2018. The problem is particularly acute for those with low to middle incomes. Among borrowers in the poorest ten per cent of the income distribution, three-in-four face becoming highly geared as interest rates rise. Yet this exposure has been masked as most discussions on household debt look at the population as a whole rather than those on low incomes.

While many of the highly-geared borrowers will still be able to refinance their loans and search for competitive deals, an estimated one-in-three of them (or 800,000) may find their options restricted because of tighter lending conditions since the financial crisis. These potential ‘mortgage prisoners’ may have no option but to remain on their existing lender’s Standard Variable Rate (SVR) leaving them fully exposed to the passing on of increases in the Bank of England’s base rate.

With these challenges in mind, the Resolution Foundation report makes specific recommendations for action now from borrowers, lenders, regulators and government to help ease this transition over the next Parliament.

The report makes 10 recommendations which include:

Calling for the Bank of England to tread carefully on interest rates until there is reliable evidence of incomes rising

The Bank of England and Office for National Statistics must develop an accurate and up-to-date measure of household incomes that accounts for changes in the finances of households across the income distribution. The report argues that the current measure is misleading and has consistently overstated income growth over recent years. An improved measure is necessary to help ensure the right calls are made on the future path of rate increases [1]

Highlighting action that should be taken now to help borrowers prepare for rising costs

• The Financial Conduct Authority should require all lenders to identify and make immediate contact with those mortgagors – an estimated 2 million – who are most vulnerable to rate rises, encouraging them to undertake a financial MOT and setting out how their repayments would rise for different plausible increases in their mortgage rate
• So long as significant numbers of mortgage prisoners remain in the market, the FCA should require lenders to justify any increase in their SVR with specific reference to changes in their funding costs in order to prevent them taking advantage of their potential monopoly position
• Lenders should be obliged to offer a medium term (e.g. five-year) fixed rate deal to existing borrowers, to give potential mortgage prisoners at least one alternative to being parked on the SVR

Helping exposed homeowners to restructure their debt or exit the market

• A big expansion of free debt advice which the FCA should fund by using the levy windfall offered by the arrival of consumer credit firms under their remit (rather than cutting the levy for existing funders as is currently proposed)
• Banks and lenders should develop a standard way of offering assisted voluntary sales – providing time and helping with the costs of people ready to leave the housing market voluntarily rather than wait for repossession
• Government should set up a new scheme – Help not to be Repossessed – which assists those borrowers who find that their pre-2009 mortgages are unaffordable, despite being in work, to trade down to shared ownership (while staying in their home)

The Resolution Foundation study stresses that with timely and co-ordinated action many of those most exposed to rate rises should be able to ride out the turbulence ahead though there is a small minority who face structural problems of affordability. It rejects the notion that some sort of debt-crunch is inevitable.

Matthew Whittaker, chief economist at the Resolution Foundation, and co-author of the report, said:

“It would be a serious mistake to think that the legacy of problem debt built up in the pre-crisis years will simply evaporate with a return to economic growth. The magnitude of the stock of debt is simply too large given expectations that income growth will be gradual at best. And, while the mortgage market largely remains competitive, tighter lending criteria means that some highly-stretched borrowers face limited choices. There is a pressing need for regulation to respond to this new context.

“We need an orderly and carefully-managed approach to managing the debt overhang in order to minimise the numbers pushed over the edge as borrowing costs rise and to improve the safety-net in place for those who can’t avoid such an outcome. A recovery which sees living standards rise right across the income distribution would, of course, be the best approach to managing debt.”

Gavin Kelly, chief executive of the Resolution Foundation, said:

“Alongside tackling the deficit, carefully managing the return to more normal interest rates is one of the great challenges of the next Parliament. As yet, the different parties have said very little about this.

“We’ll soon be emerging from an unprecedented period of ultra-low borrowing costs but households, many on low-incomes, are still carrying very high debts and have grown used to these exceptional monetary conditions. Successfully managing the adjustment to a world of more normal interest rates will be one of the key tests for the next government. The time to start acting is right now.”

Hangover Cure: dealing with the household debt overhang as interest rates rise, by Katie Blacklock and Matthew Whittaker, is published online by the Resolution Foundation on Thursday 24 July. The report is the culmination of a year-long project at the Resolution Foundation which has involved close consultation with senior figures from banking, finance, regulation and debt management organisations.

ENDS 

Notes

1. In February the Governor of the Bank of England said the base would not be increased “at least until jobs, incomes and spending were growing at sustainable rates”. The MPC identified 18 new indicators which it would publish in order to “allow others to monitor how the economy is evolving relative to our projections” with real household disposable income (RHDI) forming one of those measures. However the measure of RHDI chosen is subject to a number of weaknesses. It is an aggregate measure and gives no indication of variations in growth, either regionally or across the income distribution. Comparison of incomes derived from this measure with data of equivalised household income from the DWP’s Family Resources Survey (FRS) suggests that the measure used by the Bank tends to overstate household income growth. For example, in the period between 1998 and 2012, the RHDI per capita figure increased by 22 per cent, compared with just 14 per cent for the FRS median. In cash terms, the difference of 8 percentage points is equivalent to around £1,700 over the period for a couple household.