The Financial Policy Committee has already tightened up macro-prudential regulations governing mortgages, but it seems that three times may still not be enough.
The tighter affordability tests in the mortgage market review process are still working through and have been bolstered by the FPC’s latest decisions to impose a limit on high loan-to-income ratio mortgages and to insist that lenders test affordability at an interest rate of 3 per cent higher than the rate prevailing at origination.
But, if comments by Andrew Bailey (deputy governor for prudential regulation and chief executive of the PRA) at the Treasury select committee are anything to go by, there are still concerns that this may not secure financial stability and the latest talk is of limiting the length of mortgage terms.
The average length of mortgage terms for first-time buyers has been gradually increasing since before the crash. In 2006, 30 per cent of first-time buyers took out a loan with a term of more than 25 years. By 2009 this had increased to 43 per cent and it increased still further as house price growth has recovered. At the end of 2013, half of first-time buyer loans were for a mortgage term of more than 25 years.
Rising house prices can only be part of this increase in average mortgage terms since house prices fell during the middle of this period, even in London where there has been most increase in activity. What has been different is the pace of wage growth compared to the pace of house prices. It is this that has contributed to the erosion of buying power and helped to increase demand for longer term mortgages.
Looking to overall affordability, improving economic conditions are not yet making the balance sheets of households that much healthier. Inflation has been running ahead of wage growth for five years and because the cost of essentials have gone up disproportionately, average households have less income to service a loan with now than they did five years ago.
A longer mortgage term makes a significant difference to the monthly payment, but will increase the overall credit payment simply because interest is paid for longer. Chart 1 shows the effect on the monthly mortgage payment of purchasing a £165,000 property. It assumes a 90 per cent loan charged at a 3 per cent mortgage rate over differing mortgage terms. It is clear that extending the term gives extra leeway on affordability. So what is the problem?
The FPC is concerned that debt held for a longer time stores up risks for the economy at large, especially when those debts are initially taken out at a low-interest rate. Indeed, in a low-inflation world the debt burden hangs around longer because wages do not increase as quickly. In high inflation times, gearing up to borrow as much as possible means it is tough in the first couple of years, but the pain subsides quickly as wages increase but the debt does not.
When inflation is low (and wage growth even lower) that gearing up strategy suddenly looks less attractive. As chart 2 shows, at higher rates of wage growth the burden of mortgage payments rapidly erodes. Even with 5 per cent wage growth the burden falls by a third in seven years, but with wage growth of two per cent the burden hangs around a lot longer. That is a problem if income drops later in the term when the loan payment is still a relatively substantial burden. And that is more likely to be the case the longer the mortgage term, especially as first-time buyers get older.
The overall household debt situation has improved since the recession. Household debt as a whole is currently worth 135 per cent of household earnings. That is down from 165 per cent just before the crisis, but it is still high. The reduction in debt happened because households cut their consumption to pay down debt. That seems to have been driven by a recognition of increased vulnerability in the recession. That cut in consumption contributed to the economic slowdown and this is what the FPC is concerned about for the future.
The FPC is worried that as house prices rise, higher amounts of debt taken on to buy homes makes the economy and financial system more vulnerable in a few ways.
The first is that an increase in interest rates means that there is less money to spend on goods and services and that this then slows down or stalls the recovery in the wider economy. If that causes an increase in unemployment, the situation for borrowers worsens and the amount of funds that seep into the wider economy is squeezed further.
The second risk is about financial stability. If higher interest rates create payment difficulties that will impact on house values as increasing numbers of forced sales will reduce house prices. That in turn will have an effect on the risk profile of mortgage lenders’ balance sheets. That would increase the amount of capital the lenders are required to put aside which in turn could limit the amount of funds available to lend to both households and businesses, further squeezing the wider economy, but also leaving banks and building societies more vulnerable.
But mortgage terms are not that high when compared with some countries. Indeed at the Treasury select committee Mr Bailey described Sweden’s pattern of very long mortgages as “ridiculously long mortgages given life expectancy”. However the risks in Sweden are thought to be mitigated by a more even income stream into retirement. That is not necessarily the case in the UK, and if mortgages extend beyond the point at which people’s income falls off, there is a problem. The answer is then that we either have to borrow less or work for longer to keep income up later in life to be able to meet mortgage payments for more years. What Joy.
Fionnuala Earley is residential research director of Hamptons International
Key Points
* The tighter affordability tests in the mortgage market review process are still working through
* A longer mortgage term makes a significant difference to the monthly payment, but will increase the overall credit payment simply because interest is paid for longer
* The FPC is worried that as house prices rise, higher amounts of debt taken on to buy homes makes the economy and financial system more vulnerable
