How will borrowers cope when interest rates begin to rise?
Published: 20 May 2014 | Author: Bernard Clarke
On Sunday, during an interview for Sky News’ Murnaghan programme, the governor of the Bank of England, Mark Carney, warned about "deep structural problems" in the UK housing market. His interview came just four days after he used a lengthy press conference at the launch of the Bank’s quarterly Inflation Report to outline his views on the UK’s economic prospects and to explain what might trigger a rise in interest rates in the months ahead.
In his interview with Dermot Murnaghan, the governor re-iterated that the root cause of problems in the housing market was a shortage of supply. But developments in the housing market risks presented the “biggest risk to financial stability” in the UK, and the Bank was anxious to avoid “another big debt overhang that is going to hurt individuals and…slow the economy in the medium term.”
Many commentators have concluded from the governor’s comments that the likelihood of intervention by the Bank to address housing market risks has increased – but that the Bank has a range of tools that it would prefer to use instead of raising interest rates.
Meanwhile, earlier this week, the Resolution Foundation warned of borrowers becoming “mortgage prisoners” because affordability requirements could prevent them switching to better deals to protect against rate rises. However, lenders can sidestep new affordability rules to move these customers on to a mortgage that better suits their needs – as long as they do not increase their borrowing overall.
Prospects for higher rates
So, when will the Bank move to raise interest rates? Against a backdrop of improving economic conditions – and concern about London house price growth – many commentators had been expecting a rate rise soon, perhaps as early as this autumn. But, following the governor’s comments at his press conference last week, expectations of a rate rise have receded again.
That may be reassuring in the short term, but neither borrowers nor lenders can afford to be complacent. Higher interest rates are coming sooner or later; the questions are when, not if – and how borrowers are going to cope with higher borrowing costs?
This article looks at how the mortgage industry will deal with the prospect of higher rates and examines a number of the key issues and questions for lenders and borrowers, including:
- The clear message from the Bank that it does not intend to use interest rate policy to address risks emerging from housing and mortgage markets, but will instead deploy a wide range of other tools at its disposal.
- The extent to which measures that have already been implemented – including those introduced in recent weeks as a result of the mortgage market review – may have a dampening effect on mortgage and housing market activity. It will be some time before the effects on the market of the recent rule changes are fully understood. In our view, it would be preferable if there was a clearer understanding of the likely effects before further intervention.
- The evidence that the overwhelming majority of households will be able to adjust successfully to higher borrowing costs – even after a prolonged period during which real household incomes have come under pressure.
- What households will need to do if they are likely to struggle to cope with higher rates, and the recent evidence that some of those in difficulty will need to address their problems more urgently to have the best chance of recovering their financial position.
When will rates rise?
For lenders and borrowers, the key messages emerging from the Bank recently have been that:
- the first rate rise may now be further away than many commentators had previously thought;
- once rates do begin to rise, the pace of increase is likely to be slow and measured; and
- after a series of gradual increases, Bank rate should settle at a lower level than before the crisis.
In emphasising that inflation remains the primary target of interest rate policy, and that its use to target housing market risks would be only a “last line of defence,” the Bank’s governor, Mark Carney, was essentially re-affirming that the authorities already have an extensive range of tools that can be applied to the housing market, if necessary.
In its Financial Stability Report, published last November, the Bank gave more details of the tools at its disposal. These include urging the Treasury to rein back the Help to Buy scheme. The chancellor subsequently affirmed that he would respond positively to such a recommendation, and this week the prime minister echoed that sentiment.
Other measures that the Bank has said it could use to dampen down the housing market include introducing tighter mortgage underwriting standards; tightening capital requirements for mortgage lending or reinforcing counter-cyclical capital buffers; and recommending limits on loan-to-value, loan-to-income or debt-to-income ratios or on the length of mortgage terms.
On the timing of an increase in Bank rate, Mark Carney shed more light by emphasising that there was spare capacity in the economy:
“Despite recent progress, significant slack remains in the labour market…the MPC (monetary policy committee) judged that there was scope to make further inroads into slack before the first increase in Bank rate was necessary.”
The Bank also said last week that the outlook for inflation remains benign. Although Mark Carney stressed that “the exact timing of the first adjustment of Bank rate will be product of the evolution of the economy,” many commentators have now revised backwards their expectations of the timing of the first rate increase.
Another clear message last week was that when Bank rate does begin to rise, it will increase only slowly and to a lower level than in earlier cycles – “materially below its pre-crisis average,” according to Mark Carney. “As the expansion progresses,” he said, “there is likely to need to be gradual and limited increases in interest rates (and they) are likely to remain low relative to historic levels for some time.”
How will borrowers cope with higher rates?
The persistence of Bank rate at the historically low level of 0.5% for more than five years has helped many households cope with a prolonged period during which real incomes have been steadily eroded and are now similar to levels we saw to 2002-03. So, how will stretched households cope, even with a series of small increases in Bank rate spread out over a period of time?
Evidence suggests that the majority of households are adept at “flexing” their finances to cope with pressures caused by periods of falling real income. Broadly, households have shown they are able to adjust their discretionary spending and prioritise their mortgage payments during times of difficulty.
This was borne out by an independent study we commissioned from the social and economic research consultancy Policis, which was published in 2010. The research was based on interviews with representative groups of consumers across the country, with some questions focusing on how households had coped with pressure on their finances.
The Policis report highlighted “the reality of the flex in consumer budgets and their ability to prioritise mortgage payments.” It found that:
- almost nine out of 10 households (87%) that had experienced reduced income during the recession had adapted their budgets without significant strain on their finances; and
- consumers prioritised mortgage payments “primarily by economising on discretionary items and moving decisively away from the patterns of free and unconsidered spending that characterised the pre-crisis years.”
Moreover, prioritising mortgage payments in this way was “not creating hardship or diverting spending from essentials,” the study found. Even among the 5% experiencing the greatest financial stress – those that were struggling to meet their financial commitments and falling behind – less than half (2%) felt unable to catch up.
Clearly, there are limits to the extent that households can continue to cope with financial pressure, and many have endured another four years of declining real incomes since the Policis study was published. However, we should not underestimate the ability of households to continue to adjust to changing financial circumstances and to prioritise their debts.
Are households in denial about debt?
While the data on mortgage arrears and possessions suggests that the majority of households have continued to manage their finances successfully despite continuing budgetary pressures, the Financial Ombudsman Service (FOS) said earlier this month that some households in difficulty were not seeking help early enough.
The FOS said that an increasing number of people concerned about losing their homes were in “debt denial” and risked leaving it too late to seek help. Out of more than 13,000 people who contacted the ombudsman for help with a mortgage or secured loan problem, one third had slipped into arrears before seeking help.
The chief ombudsman, Tony Boorman, said: “Many of the cases where people face losing their home… could potentially have been avoided. So if money is tight, you should never be afraid to ask for help or guidance. Speak up sooner rather than later – there’s a lot that can be done to help before things get out of hand.”
We would endorse the chief ombudsman’s advice. The continuing decline in mortgage arrears and possessions suggests that many households are responding promptly to payment problems. Those anticipating such problems should speak with their lender at the earliest opportunity. Beginning a discussion with the lender sooner rather that later means that there are more options for developing a plan to deal with difficulties and get the household’s finances back on track.
The Bank’s recent high-profile media comments on housing market risks may mean that the prospect of further intervention is getting nearer. But an imminent rise in interest rates is now looking less likely. At some stage, however, borrowers will have to adjust to higher costs, although the Bank wants the transition to be gradual.
Despite pressure on household finances, most borrowers are able to prioritise their mortgage commitments, by flexing their budgets if necessary and cutting back on discretionary spending. That has enabled mortgage arrears and possessions to continue to decline, despite a lengthy period of falling real incomes.
Lenders are concerned, however, by any signs of an increase in “debt denial” by borrowers who fail to acknowledge that they have a problem in repaying their mortgage and leave it too late to seek help. There is usually a wider range of options for those who confront payment problems at the earliest opportunity, and lenders will respond sympathetically and try to devise a solution to help the borrower get back on track.