The end of a ‘golden era’ for mortgages

It’s been a busy week in the world of monetary policy. On Sunday, Mark Carney said that rising house prices pose the biggest threat to economic recovery. On Tuesday, the official statistics told us what we already knew – that house prices in London are soaring, by 17 per cent year-on-year. Some homeowners are finding that their houses are earning more in a year than they are. And on Wednesday, some members of the Bank of England’s Monetary Policy Committee  revealed they think the decision on when to raise rates is becoming “more balanced” – i.e. they’re minded to start voting for increases before the year is out.

Take all of these factors together and you might conclude that the cost of borrowing needs to go up sooner rather than later, to deflate what looks increasingly like a housing bubble. And it’s true that we can’t keep rates this low for ever. Persistently low interest rates lead to inefficient investment decisions – 0.5 per cent is an emergency state, not a normal one. But our research this week showed just how serious the implications of moving too soon on rates might be.

The rock-bottom rates of recent years have resulted in some spectacular mortgage windfalls. But the pressures associated with unemployment (and its near neighbour under-employment), falling wages, and cuts in state support mean that for many households, this golden period of low rates has provided welcome breathing space without doing anything to deal with the underlying affordability of the debt they amassed in the pre-crisis years.

It’s a fact that will not come as news to the Bank – its own data show that the one in five households continue to struggle to meet their mortgage payments, largely unchanged since 2009 despite five years of unprecedentedly low borrowing costs. Once rates rise, we might expect that number to head back to where it was in the early 1990s. Our own estimates suggest that the number of households facing an affordability problem will roughly double by 2018 – to 2.3m – if the base rate follows the path that the market expects. Moving any faster is only likely to increase this figure.

Rates must rise at some point. But with wage growth still barely keeping pace with inflation – after five years of falling – there’s likely to be plenty of room for manoeuvre yet. If house prices are a problem, then the Bank has been very clear that rate rises should form the last line of defence rather than the first. Macroprudential measures are largely untested, but they represent a much safer first response. If thousands of homeowners simultaneously cut back on spending, or worse fall into arrears, then the recovery could yet stall and our still fragile banking system might falter.

But we can’t delay the turning point forever. We need to prepare for when rates begin their steady march upwards again. Most obviously, borrowers must make the most of their window of opportunity, by getting their finances in order and seeking out the best deals to insulate against future rate rises. But the tightening of lending criteria since the financial crisis has created a new problem – that of the “mortgage prisoner”.

It is right that we learn the lessons of the past, and ensure we don’t again fall into the trap of overly loose lending. But the changing attitudes of lenders mean that some, who entered the market just before the crash, find that they have limited options for re-financing today. Those with little equity in their home, those with interest-only mortgages, and other non-standard customers who want to access today’s best deals, are all too often finding that the computer says no. So they are faced with the prospect of remaining on their current lender’s standard variable rate indefinitely.

Among the 2.3m facing affordability pressures in the face of modest interest rate rises, around one in three also display some potential mortgage prisoner characteristics. That leaves one in ten mortgagors – around 0.8m – in the unenviable position of being unable to insulate themselves today against a mortgage squeeze that could push them over the edge. Worse still, many of these households are positioned at the lower end of the income distribution, giving them little leeway to escape their predicament. So what can be done?

Dealing with the problem requires two steps: releasing prisoners where possible by taking a more personalised approach to re-mortgaging requests; and protecting them where it’s not. Ultimately, some will be best served by exiting the market altogether – a process that will require careful handling.

Rate rises will come, but move too soon and we risk pushing “normal” a long way down the track. In the meantime, it’s imperative that we use the breathing space afforded by low rates wisely, while it lasts, to prepare for the change.

This piece originally appeared in City A.M.