Perilous debt levels could push households to the brink if interest rates rise faster than expected

The number of families in Britain with perilous levels of debt repayments could more than double to 1.2 million if interest rates rise faster than expected in the next four years and household income growth is weak and uneven, according to new Resolution Foundation analysis. The figures suggest that the ongoing squeeze on households could leave Britain seriously exposed if interest rates were to rise faster than expected, resulting in levels of debt back at the heights last seen in the run up to the financial  crisis.

The figures are contained in the first full analysis of how rising interest rates could affect families under different scenarios for the recovery in household incomes. They follow from the adverse but plausible scenario in which interest rates rise to 3.9 per cent by 2017 (two percentage points higher than current market expectations but still below typical long term levels) and household income growth is weak and uneven (lagging behind GDP growth and being skewed away from less affluent households). Under this scenario:

• One in 20 households (5 per cent) would have perilous levels of debt in 2017, spending at least 50 per cent of their net income on repayments. This equates to over 1.2 million households, more than double the 600,000 (2 per cent) today.
• Among the poorest fifth of households, one in 14 (7 per cent) would have perilous levels of debt—higher than the 5 per cent today.
• 5.8 million households (21 per cent) would be ‘debt-loaded’, spending more than a quarter of net income on repayments (compared to 3.7 million – 14 per cent – today).

The scenario would see Britain return to higher levels of perilous household debt than those in 2007, just before the financial crisis. The number of households in ‘debt peril’ (spending more than half their net income on debt repayments) stood at 870,000 in 2007, just before the crash, but had fallen to 600,000 by 2011 as interest rates fell and households deleveraged during the recession.

While this is only one of the scenarios looked at by the Resolution Foundation research, it would have profound implications for households, banks and policy makers and for the wider economic recovery. Although pessimistic over interest rates compared to current market expectations, it is still based on cautious assumptions, such as GDP growth rising in line with the OBR’s projections, household debt growing as expected by the OBR to around £2 trillion by 2017, and the spread between market interest rates faced by borrowers and the Bank of England rate falling halfway back to its historic level.

The figures reveal the impact of a rise in the base rate under these conditions.

The timely findings come as new Bank of England governor Mark Carney finishes his second week in the job. Carney has signalled an intention to hold down interest rates for longer than otherwise may have occurred—and today’s report confirms the risks of an early rise. Yet with few able to say with confidence what interest rates will be in 2017, the findings also stress how little freedom for manoeuvre the Governor and Monetary Policy Committee may have if the squeeze on household incomes continues and external factors—or a domestically generated housing boom—generate pressure for higher rates.

FULL FINDINGS

The new analysis also looks at two main scenarios for household income growth in the recovery, and at a range of interest rate scenarios in each case:

• A best case scenario in which household income growth is strong and shared (tracking GDP and being shared evenly between poor and rich households). In this optimistic scenario – which would be a marked departure from recent experience – if interest rates rise no higher than the 1.9 per cent the market expects, the number of households in debt peril rises to 700,000 by 2017. If interest rates instead rise 1 percentage point more than expected by 2017, the number of household in debt peril rises to 880,000. If interest rates rise by 2 percentage points the figure rises to 1.1 million.
• A bad scenario in which household income growth is slower and uneven (falling behind GDP growth and being focused more on rich households). In this scenario, the number of households in debt peril rises to 810,000 even with interest rates at 1.9 per cent in 2017. The figure rises to 1 million if interest rates rise 1 percentage points above expectations by 2017 (to 2.9 per cent) and to 1.2 million with interest rates at 3.9 per cent in 2017.

In addition to looking at households with a ‘perilous’ amount of debt the analysis also looks at the number of households that are ‘debt-loaded’, spending more than a quarter of their net income on debt repayments. Today around 3.7 million households are debt-loaded but the analysis reveals how this could rise in the coming years:

• Under the best case scenario of strong and shared income growth, with interest rates at 1.9 per cent in 2017, the number of debt-loaded households rises to 4.1 million. With interest rates at 2.9 per cent in 2017, the figure rises to 4.9 million and with interest rates at 3.9 per cent it rises to 5.4 million
• Under the bad growth scenario of slow and uneven household income growth, the number of debt-loaded households rises to 4.5 million with interest rates at 1.9 per cent in 2017. This figure rises to 5.2 million with interest rates at 2.9 per cent in 2017 and to 5.8 million if interest rates rose to 3.9 per cent.Finally, the analysis suggests that perilous levels of debt are likely to fall increasingly on families with children and on the poorest fifth of households:
• Currently 38 per cent of households in debt peril have children. This rises under all scenarios analysed and to 43 per cent in the worst case scenario in which household income growth is slow and uneven and interest rates at 2 per cent above market expectations in 2017
• Currently 2 per cent of all households have perilous levels of debt and 5 per cent of households in the poorest fifth. This figure jumps to 7 per cent of poorer households under a bad growth scenario in which interest rates rise 2 per cent above current expectations by 2017.

The findings are based on original analysis by the Resolution Foundation of the Living Costs and Food Survey and of the Department of Work and Pensions Households Below Average Income dataset. Baseline forecasts for the total level of household debt and interest rates are taken from the Office for Budget Responsibility and from market expectations as reported by the Bank of England.

Matthew Whittaker, senior economist at the Resolution Foundation, said:

“There is now the real prospect that a large number of households already burdened with debt could collapse under its weight if economic conditions tighten.  Even if interest rates stay in line with expectations, we are likely to see a rise in the number of families struggling with heavy levels of repayment over the coming years.

“But if the squeeze on household incomes continues, Britain could be left in a fragile position, with even moderate additional increases in interest rates leading to a major  surge in families with dangerous debt levels – especially among worse-off households. With no one able to predict with confidence where interest rates will be in 2017, these are sobering findings.

“Policy makers and lenders need to use the current period of record low rates to defuse debt problems rather than storing them up for the future. Soaring levels of problem debt repayments could well become one of the major policy challenges of the next parliament—and one there’s been almost no discussion about.”

The Resolution Foundation analysis is launched today at an event featuring David Miles of the Bank of England’s Monetary Policy Committee, Kate Barker of the Office for Budget Responsibility and Gillian Tett of the Financial Times with Stephanie Flanders, the BBC’s Economics Editor, chairing.

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