UK housing market forecast: mortgages will become unaffordable if interest rates rise to 1.5pc

The second rise to the Bank Rate in as many months, from 0.25pc to 0.5pc, which is expected later today, will be a blow to the housing market.

Further rises are on the near horizon, posing a looming threat to housing market affordability and home prices.

Pantheon Macroeconomics, a research firm, has forecast that when interest rates rise, house price growth will fail to maintain its recent momentum and flatline to month-on-month gains of just 0.2pc for the first half of 2022.

“House prices will be very responsive to a higher Bank Rates because they depend on new mortgage rates, not on the effective rate,” it said.

More rate rises are coming

In anticipation of rate rises towards the end of last year, lenders began increasing mortgage rates by a third and pulled sub-1pc deals from the market. The trend continued into 2022 and borrowers are already paying hundreds of pounds more on repayments.

Rapid house price growth in the wake of the pandemic means that the mortgage loan-to-income ratio for first-time buyers is at a record high. This means that affordability is already under exceptional strain, although this demographic has so far been spared big rate rises by banks.

As inflation continues well above the Bank's target rate of 2pc, the Office for Budget Responsibility, the Treasury's official forecaster, expects that the Bank Rate will rise to 0.75pc by the end of 2023. This would trigger a 13pc year-on-year jump in interest rates on mortgages.

The jump could be far more extreme. If inflation is driven by pressures from the product or labour markets, rather than temporary supply chain disruptions, the Bank Rate could instead rise to 3.5pc. This would be the highest level since November 2008.

Any rate rise will hit hard in the wake of rapid house price growth that has dramatically reduced affordability. In short, it would trigger the end of the house price boom.

Hikes will hammer affordability

When the Bank Rate was at 0.1pc, a homeowner spent 38pc of the median income to service an 80pc mortgage on an average priced home  – or £827 per month, according to Capital Economics consultants.

Now it has risen to 0.5pc, and if immediately passed into mortgage borrowers, the monthly costs would rise to £881, or 40.3pc of their disposable income. However, lenders will likely absorb some of the hike. Capital Economics estimated that in this scenario monthly costs would rise to £832 — still roughly 38pc of income.

However, at 1.5pc, monthly mortgage costs would jump £100 to £932. This would be equivalent to 42.6pc of median earnings. If the hike was passed entirely to borrowers, the share would hit 45pc. Both scenarios mean homes would be more unaffordable than any point since 2008.

A hike to 3pc would mean a £200 jump in monthly payments, even if it was partially absorbed by the banks. This would take the cost to 47.5pc of earnings.

The role of growing house prices

The last time mortgages were so expensive, homes were cheaper in relation to earnings. In the last three months of 2008, the average house cost 6.3 times average earnings. Today, it is 7.4 times.

Record house price growth in the wake of the pandemic has meant the value of homes is more out of kilter with wages than at any other time in the past 14 years. Normally, this would limit house prices but record low mortgage rates have boosted the market. In real terms, homes have been exceptionally cheap to buy.

Yet if rates rise significantly, buyers will no longer be shielded from reality, and buying power would evaporate.

This would come at a bad time for the housing market. The artificial incentive of the stamp duty holiday is long over. Record house price growth has started to hit affordability and the Help to Buy scheme is winding down.

Simon Rubinsohn, of the Royal Institution of Chartered Surveyors, said momentum was flat for new buyer inquiries. The interest rate rise will further dampen sentiment, though it would take a bigger jump than the anticipated rises to trigger any material change to house prices, Mr Rubinsohn said. “If the Bank Rate hit 2pc to 3pc, it would be a shock.”

The spectre of forced sellers

Meanwhile, existing homeowners could suddenly find their mortgages were unaffordable. Andrew Wishart, of Capital Economics, said: “When mortgage payments get into the high 40s as a percentage of median income, it usually spells trouble ahead.”

A Bank Rate hike to 2pc would bring mortgage rates of around 4pc and trigger a jump in households struggling to repay their mortgages, said Mr Wishart.

Restrictions on lending and affordability criteria in the wake of the financial crisis have meant that the British property market has improved safeguards. Before the crash, one in six borrowers only had 10pc equity in their home, Mr Wishart said. That has dropped to 3pc. “As a result, homeowners have more skin in the game and a bigger incentive to keep up mortgage repayments." Stress tests are also much more rigorous, making repossessions less likely.

Nonetheless, higher rates could coincide with a sharp slowdown in the economy, leading to job losses. “That would cause some borrowers to fall into arrears and repossessions would rise even if they have a significant equity stake in the house,” said Mr Wishart.

British homeowners would be hit harder

Rate rises pose a bigger risk to the British housing market than in other countries such as the United States because a larger share of homeowners here are on variable rate mortgages, said Vicky Redwood, of Capital Economics.

Variable rate mortgages are periodically adjusted according to what the Bank of England does, meaning increases would quickly translate into higher costs for homeowners. Coupled with the rapidly rising household bills, this could put pressure on affordability and, in turn, increase the likelihood of forced sellers.

The British market has been moving towards fixed-rate mortgages. Between April and June last year, 6pc of new mortgages issued in the UK were on variable rates – down from 21pc in the same period in 2015. In the US, the share was 3.6pc. 

But the crucial difference is that British homeowners take out much shorter deals – two to five years compared with 30 years in the US. Because of the shorter terms, one in five mortgaged homeowners in Britain have a variable rate contract compared to one in 20 in the US.

Problems of affordability will show up much faster in Britain than in America, Mr Wishart said.

Via @TheTelegraph