With these threats looming, the BoE fears that lenders have become complacent, assuming that the relatively good economic conditions will continue, leading them to relax mortgage lending criteria and reduce the amount of capital they have set aside to insulate themselves in the event of a downturn.
The growing gap between mortgages and wages.
The underlying problem is that the gap between people’s wages and house prices has been increasing. For several years wages have been stagnant, with many people taking real terms pay cuts once inflation is factored in. At the same time, house prices have been continuing to grow, forcing people to take out much bigger mortgages in order to buy a property.
According to the BoE report; “The average house price for first-time buyers increased from around £50,000 in 1997 to over £200,000 in 2016. Over the same period, the size of a typical deposit for a first-time buyer increased from less than £5,000 to over £30,000.”
This has been exacerbated by historically low levels of house building. Over the last 50 years, the UK has cut the number of new homes it is building in half, constricting supply and forcing up prices.
The Bank also expressed its concern about new mortgage products entering the market, in particular mortgages with zero fees. These fee free mortgages now account for 45% of all UK mortgages, but they are especially popular with lower income home buyers, who would be most at risk of defaulting should interest rates go up or if their personal finances were to deteriorate.
This has led to increasing numbers of households living with high debt-service ratios (DSR). This is the total mortgage repayments as a percentage of monthly income. The higher the DSR, the greater the chances of a borrower falling into arrears and DSRs have been steadily increasing, simply because house prices have been going up.
Consumer debt worries.
At the same time, consumer debt is rising rapidly, by more than 10% per year, led by credit card and car loans. This has created a worry that, in the event of a downturn, consumers might create a contagion as they choose to default on credit card or car loan payments in order to keep up payments on a mortgage that is becoming unaffordable.
Speaking at the launch of the Financial Stability Report, Mark Carney, Governor of the Bank of England, said; “Consumer credit has increased rapidly. Lending conditions in the mortgage market are becoming easier. And lenders may be placing undue weight on the recent performance of loans in benign conditions.”
In the Bank’s worst case scenario, a 3% increase in unemployment, from 5% where it currently stands up to 8%, the number of households with high debt-service ratios would suddenly double.
Dangerous feedback loop.
Together, these risks could amount to the ‘self-reinforcing feedback loop’ between lenders and borrowers, posing significant risks to both and to the wider economy.
According to the BoE report; “A feedback loop between house prices and credit also arises in a downturn. An economic slowdown can reduce house prices. Due to the role of housing as collateral, lower house prices reduce the demand for, and supply of, credit.
“Expectations of further price reductions, which can result in sales of houses at heavily discounted prices (‘fire sales’), can further amplify house price falls, reinforcing the adverse feedback loop. The resulting deterioration in borrowers’ and lenders’ resilience will intensify a downturn.”
The Bank regards these dangers as sufficiently urgent that they are bringing their annual assessment of lenders’ potential losses in the event of a recession forward this year, from November to September.
The Bank’s response.
In order to head off these dangers to the mortgage market, the Bank of England is introducing stringent new rules on mortgage affordability, forcing borrowers to prove that they could afford repayments of almost double the expected monthly cost of their loan.
Under the new rules, lenders will have to stress test a borrower’s ability to meet their monthly payments at 3% above the rate that will apply when the introductory offer ends, this could lead to banks stress testing at a very high rate of 8.75%.
These changes, however, will only apply to new mortgages and won’t impact on existing loans, so they won’t protect anyone whose existing mortgage becomes unaffordable to them should they be impacted by a downturn in the economy.
We can help.
The Bank of England’s concerns about mortgage affordability raises worries that house prices may be headed for a fall, which could leave many homeowners, especially those with significant mortgage debt, vulnerable to negative equity.
If you own a property in negative equity and you’re worried about the affordability of your mortgage, contact our debt specialists for a consultation.