UK: Deloitte Monday Briefing: Can Homeowners Cope With Higher Interest Rates?

Last Updated: 11 March 2014
Article by Ian Stewart
  • A rising tide of upbeat data from the UK economy has been accompanied by growing speculation about the timing of interest rate rises. After six years of exceptionally low interest rates how would mortgage holders cope with the turn in the interest rate cycle?
  • Massive monetary easing helped stop the deep recession turning into a deep depression. Ultra-low interest rates slashed debt-servicing costs and propped up house prices, helping shield consumers from the worst of the crisis.
  • The policy worked. Housing repossessions stayed well below the levels reached in the recession of the early-1990s and UK house prices fell far less, than, for instance, in the US.
  • UK consumers have made some progress in strengthening their balance sheets in recent years. Savings rates have recovered after a long period of decline. Levels of consumer debt relative to income have fallen, from over 160% in 2008 to about 140% today.
  • But UK consumer finances are hardly in great shape.  At 140% the debt-to-income ratio is well above the levels that prevailed before the crisis. Consumer incomes have been squeezed hard. For those aspiring to get on or move up the housing ladder house prices are not especially low relative to incomes.
  • The average UK mortgage is £87,000 but this conceals an uneven distribution across the population. By and large younger people are more indebted and have lower levels of savings than the  under 50s. Low interest rates transfer income from older net savers to younger net borrowers.
  • 47% of households have a debt-to-income ratio of less than two, a manageable level, but for 16% the debt-to-income ratio is above four. Another measure of vulnerability is the growth in the number of households with high loan-to-value ratios. 15% of those with mortgages have a loan-to-value ratio in the range 75-100%, up from 9% in 2007.
  • The Bank of England has modelled the effects of higher interest rates on consumers. It estimated that, with incomes held at current levels, a 2.5 percentage point increase in mortgage rates would increase the proportion of incomes going on debt servicing from an average of 21% to around 28%. The proportion of what the Bank calls vulnerable mortgagors, with repayments in excess of 35% of their income, would roughly double, to around 16% of mortgagors. Half of all mortgagors say a 2.5 percentage point rise in their interest rate would force them to cut back other spending or work longer hours to meet their mortgage payments.
  • Such an outcome could halt the consumer recovery in its tracks. But like all modelling exercises tweaking the assumptions brings very different outcomes.
  • For a start, Bank of England has given every indication that interest rates will rise only gradually. In a speech last week, Professor David Miles, a member of the Bank of England's interest rate setting Monetary Policy Committee, said that, "The new normal for monetary policy will probably involve setting Bank Rate on average at a lower level than before the crisis" and suggested that rates are likely to stay below 3.0% for some years to come. Financial markets assume base rates will not reach the 3.0% mark for at least four years. Our hunch is that UK rates will rise gradually from early next year from a current 0.5% to around 3.0% by late 2017 – an increase of 2.5% in four years.
  • Borrowers are unlikely to see such base rate rises fully translate into higher mortgage costs. During the downturn the spread between base rates and mortgage rates widened as lenders tried to bolster their margins. As interest rates rise this spread is likely to narrow, meaning that mortgage rates are likely to rise at a slower pace than the Bank's base rate.
  • Consumers should also be helped by a recovery in incomes.  The official, independent forecasting body, the Office for Budget Responsibility, forecasts that household incomes will rise by an average of 3.6% a year for the next five years giving a substantial uplift to consumer spending power.
  • When the Bank repeated its modelling exercise for the effects of a 2.5% rise in borrowing costs factoring in a 20% rise in incomes the outcomes were radically different. The proportion of vulnerable mortgagors – those with repayments in excess of 35% of their income – was hardly changed. And just 3% of mortgagors said such a rise in their interest rate would force them to cut back other spending or work longer hours to meet their mortgage payments.
  • Most forecasters – us included - assume interest rates will rise only slowly and incomes will recover.
  • Homeowners should be able to cope with this.
  • The nightmare outcome is high inflation, which forces the Bank to raise interest rates sharply, coupled with further declines in incomes.  The Bank of England knows that this would kill the recovery. Its fervent hope is that inflation stays low and that recovering productivity enables companies to start raising pay.

MARKETS & NEWS

UK's FTSE 100 ended the week down 0.6%.

Here are some recent news stories that caught our eye as reflecting key economic themes:

KEY THEMES

  • Greece's 10-year government borrowing costs fell below 7.0% for the first time since early 2010, and Italy's fell below 3.5% for the first time since early 2006
  • Gold prices rose for the fourth consecutive week as concern of prolonged political unrest in Ukraine fuelled demand for safe-haven assets
  • British housebuilder Bovis Homes announced a 48% annual rise in pre-tax profits for 2013, driven by the recovering housing market
  • The city of Rome could face bankruptcy after the Italian parliament rejected a new funding bill to address the city's €816m budget deficit
  • Brazil's biggest sugar producer, Cosan, made a $3bn takeover bid for a railway operator, in an effort to improve logistics and speed up shipments of sugar in Brazil
  • According to official statistics, the average British worker took 4.4 days off for illness in 2013, compared with 7.2 days in 1993
  • The German and Finnish ministries have written to the European Commission to express concern at apparent "watering down" of austerity demands on eurozone economies, according to an 8-page page memo seen by the Financial Times
  • A survey by advertising group WPP found that 35% of Chinese cite the US as their "ideal country" today, more than any other country
  • Boeing revealed that it is developing a smartphone device that deletes all its data if any unauthorized attempt is made to crack it open or access data
  • Bloomberg reports that Rolls Royce is developing ideas to build crewless drone ships, controlled by captains on dry land
  • The Irish unemployment rate fell to 12.1% in the last three months of 2013, with the number of people in employment continuing to rise
  • The Spanish government announced that it is selling 7.5% of Bankia, in the first step towards reprivatising the nationalised banking group
  • The price of virtual currency Bitcoin fell 20% in a day after one of its leading major exchanges, Mt.Gox, went offline amid fears that it is on the verge of bankruptcy
  • The Financial Times reports that the Greek government contends that its financial system requires less than €6bn of new capital, while international monitors insist it needs at least three times that amount
  • Industrial output in Japan rose at its quickest monthly pace since June 2011 last month, rising at a faster-than-expected monthly rate of 4.0%
  • Figures released by the People's Bank of China show a sharp rise in the use of debit and credit cards among Chinese consumers, with 4.2bn bank cards now in circulation – enough for every mainlander to have at least three
  • The president of Kazakhstan wants to drop the last 4 letters from the end of the country's name to improve its image and set it apart from neighbours such as Tajikistan, Turkmenistan and Uzbekistan – 'Taking-a-stan'

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