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Are mortgage borrowers prepared for rising interest rates?


Published: 17 July 2017 | Author: James Tatch

Following an unexpected three votes in favour of a rate rise from the Bank of England’s monetary policy committee  members in June, there's renewed speculation that an increase is on the cards sooner, rather than later. The most hawkish commentators suggest this could come as early as this August. Market expectations (as encapsulated by the swap curve) are volatile but, at the time of writing, they suggest the first rise could be in about 12 months.

Any change in interest rates will see winners and losers. Savers, having experienced years of low returns, will see a welcome benefit. But many borrowers will see an increase in their monthly payments, both on their mortgage and other loans.

In previous articles we have explained why a rise or fall in Bank rate, while clearly a strong influence, does not necessarily translate into a like-for-like change in mortgage rates. Here, we use our data to give some insights into how borrowers might be affected.

How low did they go?

Chart 1 shows rates over the past decade or so. For more than eight years, Bank rate was rooted at a then-historic low of 0.5%, before a further cut last year to 0.25%. Over the same period, rates on both new and outstanding mortgages continued to fall, aided in part by cheaper funding costs, as well as benign wider economic conditions.

Chart 1: Mortgage rates relative to Bank rate

Chart showing Mortgage rates relative to Bank rate

Source: Bank of England

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The Bank has long signalled that rate rises, when they do come, will be gradual. And previous research suggests that consumers themselves believe they would cope with rising rates.

Without trying to second-guess the exact size and timing of the next rise, we can use our regulated mortgage survey (RMS) data to gauge the resilience of mortgage borrowers to a rate rise.

Most borrowers are on fixed rates

The first thing to note is that many borrowers will see no immediate change to their mortgage payment at all. As Chart 2 shows, over half of all outstanding regulated loans are currently on fixed rates, as is more than 80% of all new lending.

Chart 2: Proportion of new and existing loans on fixed rates

Chart showing proportion of new and exisitng loans on fixed rates

Source: Bank of England

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However, roughly half of the 4.2 million regulated mortgage borrowers on fixed rates will come to the end of their deal this year or next. So, while their mortgage costs wouldn’t be immediately affected by a Bank rate rise, there would be an impact for many fairly soon.

Many borrowers could re-finance onto new low rate deals

Of course, those borrowers may never move on to the reversion rate at the end of their deal period; many re-finance at (or before) the end of their fixed rate, and with current deal rates so low  there are compelling reasons for them doing so.

Although the best rates are available to those borrowing a lower proportion of their property's value, rates are still extremely low by historical standards even for higher loan-to-value (LTV) loans. At the time of writing, Moneyfacts data shows average two-year fixed rate deals of 1.57% up to 60% LTV, and 2.46% up to 75% LTV. Even up to 90% LTV, deals are available at 2.73%.

Supporting this, our RMS data draws out some positive findings: of the fixed rate mortgages due to expire and move to a reversion rate by the end of 2018, half have better than 60% LTV and so would, in principle, meet the LTV criteria for the best new deal rates. Another quarter have less than 75%, and almost all the rest are at less than 90%.

Our data cannot tell us whether all these borrowers would get through the other required affordability assessments to qualify for the best rates. But we do know that almost all have enough equity to do so, even in the context of moderately increasing rates.

How about borrowers currently on variable rates?

Around 3.9 million mortgages captured in the RMS data are currently on a variable rate product. But the RMS covers regulated loans only, and there is also a long tail of older home-owner loans taken out before regulation was introduced in 2004. In total, around 1.1 million such home-owner loans outstanding (with an average balance of around £80,000) are not covered in the RMS. Many of these older loans are likely to be on standard variable rates (SVRs), although we have no further data on these borrowers or their mortgages.

Characteristics of borrowers with variable rates

For the 3.9 million variable rate borrowers who are captured within RMS data, we can draw out some useful profile information.

1.     Standard variable rate borrowers are on higher rates, but have lower typical debt

Most new lending is at a fixed rate – which means most of the two million outstanding SVR loans are older, and smaller – taken out when house prices were lower.

Even among the newer loans captured in the RMS, the typical borrower currently on a standard variable rate (SVR) has a balance of £91,000, compared to £141,000 for those on fixed rates. The outstanding average interest rate for SVR loans is higher – 3.46%, compared to 2.88% for outstanding fixed rate loans. However, these SVR borrowers were, on average, slightly less leveraged when their mortgage began, having taken out loans at around 2.9 times income, compared to 3.1 times income for a fixed rate borrower.

2.     Other variable rate borrowers have higher debt, but are on lower rates

The 1.4 million borrowers currently on tracker rate deals (almost all of which are Bank rate trackers) have higher average balances although, at £131,000, still lower than those on fixed rates. However, the average interest rate on outstanding tracker rate mortgages is 1.73%, considerably below typical rates for any other rate type. Like SVR borrowers, they are also lower leveraged than fixed rate borrowers, at 2.8 times income on average.

3.     Variable rate borrowers have lower monthly payments

For both SVR and tracker rate borrowers, these two factors – size of debt and interest rate – result in typical mortgage payments that are lower than those for fixed rate customers. This is true for borrowers on interest-only and repayment terms (although the absolute amounts obviously differ). Average monthly payments are currently £525 on average for an SVR customer, £566 for a borrower on a tracker rate and £741 for borrowers on fixed rates.

Based on the average balances above, an illustrative 1% rise in rates (or, and a more likely scenario, a succession of quarter or half percentage point increases) would translate to an additional £76 in monthly mortgage payments for the typical outstanding SVR loan, and £109 for a tracker.

4.     Lenders build breathing space into their lending decisions

Since the Financial Conduct Authority’s mortgage market review (MMR) rules came into force in April 2014, lenders are required to assess affordability by testing whether the borrower can afford the mortgage payments after deducting necessary expenditure from their household income. And they test this not at the initial interest rate but under a higher stressed rate that takes into account market expectations of future rate increases.

This ensures that mortgages lent post-MMR already have resilience to higher interest rates factored in from the outset. And the FCA acknowledged in its MMR policy statement that the vast majority of the industry already stress-tested affordability under a higher interest rate before the MMR came into being. So, testing for interest rate resilience is a well-established part of UK mortgage underwriting, albeit that the process is now more prescriptive than it was previously.

Looking at mortgages lent since 2015 (the period for which we have this data) Chart 3 shows that 92% of mortgages still outstanding were stress-tested for an interest rate at least 3% above their current interest rate. And, even for recent borrowers now on SVR, 84% have been stress tested to 3% or more above what they currently pay.

Chart 3: Gap between stress rate and current interest rate, mortgages advanced since 2015

Chart showing gap between stress rate and current interest rate, mortgages advanced since 2015

Source: UK Finance Regulated Mortgage Survey

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1. Data cover regulated mortgages originated in 2015 and 2016, outstanding at December 2016.

2. Gap calculated as the difference between stressed interest rate used in affordability assessment when loan was approved and the interest rate paid at December 2016.

3. Excludes loans for which either no stress test or income-expenditure test is required.

Encouraging signs, but beware the “known unknowns”

Overall then, while borrowers are unlikely to welcome higher rates, most  look well placed to withstand rate increases higher than anything that is likely over the next couple of years.

But, of course, consumers do not take out mortgages in a vacuum – many will have other loans, savings or other investments, all of which are affected by rate rises, just as mortgages are. For those with high savings, the benefits may outweigh the additional mortgage costs. But for those with significant other borrowings, the reverse will be true. However, we do not have sufficient data on the wider net financial position of mortgage borrowers to provide insight on the net balance of winners and losers.

We also do not know how either the income or expenditure of any borrower has evolved in the years since they took out their mortgage. However, we do know that, in aggregate, real wage growth has been weak or negative for large periods over the past few years, and this is likely to remain the case in the short term.

At the same time, we are in a world where many borrowers – including around 2.4 million who took out their first mortgage in the last 10 years – have never experienced a Bank rate rise as a mortgage borrower. And while the vast majority of these will have come to the end of at least one deal rate, most will have then re-financed on to another deal reflecting the continuing ultra-low rate environment, or simply continued on an SVR which, in many cases, will itself be fairly attractive. Because of this, there is a risk of complacency – that some will not have factored this in to their financial planning.

We do not have a crystal ball. But it is certain that rates will eventually rise and, if market expectations are right, sooner rather than later. When this happens, it is vital that borrowers are alive to the impact this will have on their own household finances.

Lending practice and regulation go a long way to helping ensure borrowers have a buffer to absorb increases. But ultimately borrowers still need to look at their own finances to ensure they are resilient as the era of rock-bottom rates unwinds.