The recovery in the housing market has been underpinned by low interest rates. However, any increase in interest rates from such a low base will substantially impact on the monthly mortgage costs of many households and stretch affordability.

We calculate that for every 1% increase in mortgage interest rates the total annual housing bill in the UK will rise by £10 billion. If house prices rise too dramatically when rates are low, thereby prompting higher levels of borrowing, the impact of rate rises will be all the greater.

This begs the question whether parts of the housing market need reining in?

The Nationwide House Price Index shows that average annual house price growth reached 11.5% at the end of the second quarter of 2014. In itself, such growth is not unusual at this point in the recovery cycle, but policymakers have expressed concern over a potential house price boom that would require households to take on more debt, and the potential risks to the economy when interest rates do rise.

In reality much of that concern focuses on London. The Nationwide Index has recorded annual price growth of over 26% in the capital, which suggests that prices are 30% above their peak (whereas in the North West they are on average 10% below).

Click Figure 1.1 below to enlarge

A £33 billion interest bill

In the current low interest rate environment this is less of a concern. Current mortgage rates, combined with falling levels of owner occupation, mean that the total annual cost of mortgage interest stands at nearly £33 billion across the UK. This is almost exactly where it stood 10 years ago and well below the £61 billion reached in the third quarter of 2008 (Figure 1.1).

Furthermore, the total mortgage interest bill is 30% below the annual cost of housing borne by a much smaller pool of private tenants. Looked at another way, the average amount of mortgage interest paid by mortgaged owner occupiers is less than the average rent paid in the social housing sector.

This reflects the fact that many of the 8.9 million mortgaged owner occupiers have paid down their mortgage over their period of home ownership, with the aim of joining the 8.1 million owner occupiers with no mortgage bill whatsoever.

The erosion of outstanding mortgage debt requires homeowners to make capital repayments, in a form of enforced savings plan. Compared to interest alone, capital repayments currently more than double the costs of housing for those with a mortgage and makes a significant contribution to the total cost of housing of £142 billion per annum across all tenures in Britain as a whole.

Economic risk

How much and how quickly will the total cost of housing increase as interest rates rise? Bank of England Governor, Mark Carney has indicated that the “new normal” for bank base rates will be 2.5%, potentially applying as early as 2017.

Such a 2% increase would result in a £20 billion rise in the total amount of mortgage interest paid, up to within 10% of its recent peak. This would equate to an extra £2,360 a year per mortgaged household across Britain and £4,000 per mortgaged household in London. The greatest risk will be to younger households with the largest mortgages relative to household income.

Regulatory response

It is therefore of little surprise that the regulatory arm of the Bank of England has a close eye on the extent of high loan to income mortgage lending. There is a particular focus on London, where rapid price growth has been accompanied by a steady increase in the proportion of new mortgages at income multiples of 4.5 times or more. According to a recent Financial Policy Committee (FPC) report, one in five new mortgages in the capital falls into this category, more than double the proportion across the UK as a whole.

Much is dependent on the Mortgage Market Review and the extent to which this ensures that borrowers do not take on unsustainable levels of debt.

Cooling effect

This, together with the prospect of interest rate rises, is likely to curb house price growth in the mortgaged market and, in time, will act as a drag on growth in the more equity rich markets.

There are early signs that this will cool the housing market. Mortgage approvals were 12% lower in June than in January on a seasonally adjusted basis. The Royal Institution of Chartered Surveyors (RICS) reported a fall in new buyer enquiries in London in both May and June

This indicates that the rate of price growth in London in particular may have peaked and could slow significantly, especially with a general election on the horizon. It is also likely to mean that other markets with more remaining capacity for price growth do not witness the same peak levels of annual increases that have followed price rises in London in previous housing market cycles.

Taken from
Residential Property Focus Q3 2014