One of the key features distinguishing this housing market downturn from that of the early 1990s is the effect of low interest rates. There is a sense they have softened the blow for much of the mortgaged UK housing market. They certainly have tempered repossession levels, and mortgages are currently more affordable for those able to meet the tighter lending criteria.

Headline statistics from the Council of Mortgage Lenders (CML) show that over the past 12 months average interest payments as a percentage of a borrower’s income are currently just 10.8%, which is below the 10-year average of 14%. This creation of a mortgage affordability cushion is helping to underpin house prices.

As a measure of mortgage affordability, however, this cushion is unlikely to give a meaningful assessment of the future capacity for house price growth. Compared with most of the last decade, we face the prospect of increasing interest rates that could rapidly eat into the cushion, a factor buyers are likely to be mindful of during these uncertain economic times.

Medium-term measure

It is arguably more appropriate to look at a medium-term measure of affordability, based on five-year fixed interest rates. Substituting these rates for the prevailing abnormally low interest rate would increase the ratio of interest payments to a borrower’s income to 14.7%.

This is substantially closer to the comparable overall 15.3% 10-year average than headline figures seem to suggest (see Graph 4.1).

For homeowners with a mortgage this means the affordability cushion is actually much smaller, so house price growth prospects for the next five years are much lower than they were in, say, 1995.

More positively, this factor also suggests that, for buyers who are able to obtain mortgage finance, current house prices are broadly sustainable even when interest rates rise.

Capital repayments

Another major difference between now and the early 1990s is the substantial change to the mortgage market, a change that looks to be entrenched and has major implications for the way we view affordability.

Specifically, with fewer interest only mortgages available the cost of capital repayments becomes increasingly relevant. Add the cost of mortgage capital repayments into the calculation and the five-year cost of all mortgage payments rises to 22.4% of income, slightly higher than the 10-year average of 21.8%.

This has a major bearing on the renting vs buying equation. Though the cost of renting is closely aligned to the cost of buying with an interest only mortgage, when capital repayments are factored in home ownership becomes a more expensive option.

Combined with the other increases in the average cost of living due to persistently high inflation, those additional capital repayment costs will act as a disincentive to buy, whatever the longer-term financial benefits of home ownership.

This does not preclude a return of house price growth, especially while cash and equity rich buyers are increasingly dictating house price movements.

It does, however, mean that the potential for growth in earnings is now far more critical to price growth in the mortgaged sector than the headline affordability statistics currently suggest.

Taken from:
Residential Property Focus, Q3 2011