MortgagesOct 2 2014

Household debt still a bugbear

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

Now that the economy and housing markets are recovering from the credit crunch, it’s worth considering how the make-up of lending in the years since the crunch may affect the risk profile for the housing market, as well as the future recovery of the wider economy.

The latest Bank of England data on the characteristics of mortgage lending over time shows the profile of lending, including interest rates, arrears, lending ratios and other relevant information.

In Q2 2007 total outstanding mortgage balances were £1.1 trillion. By Q2 2014 this had increased to £1.25 trillion. This 17 per cent increase over seven years was a stark contrast to the 119 per cent rise of the previous seven-year period.

Analysis

That growth in debt is one reason why the Bank of England is concerned about the household sector today. In its latest Quarterly Bulletin, the Bank’s analysts consider how much the level of outstanding debt affects the ability, and desire, of households to spend. Survey evidence suggests that large cuts in spending by highly indebted households after 2007 reflect a combination of tighter credit conditions and increased concerns about the ability to make future debt repayments.

Its analysis shows that cuts in spending associated with debt may have reduced private consumption by around 2 per cent after 2007, increasing the depth of the recession and preventing an early recovery.

Since the crash there has indeed been an improvement in the quality of lending in terms of the affordability risks. In the period 2000 to 2007 the average loan-to-value ratio recorded by CML’s survey was 79 per cent, compared with 75 per cent between 2008 and 2014. A more detailed pre-2007 breakdown is not available from the Bank of England, but the later data chimes, showing around two-thirds of loans since 2007 have been at LTV ratios of 75 per cent or less.

Of the loans taken out at the peak of the market in 2007 to mid-2008, 14 per cent were at LTV ratios of more than 90 per cent, while after the crunch that proportion fell to just 2.8 per cent.

In that year and a half period from Q1 2007 to Q2 2008, about two-thirds were taken out at an average mortgage rate of 5.73 per cent. It is fair to assume loans taken out at this time were some of the riskiest in terms of affordability. Indeed the Bank of England data tells us that about 10 per cent of them in the 90 per cent or more LTV bracket also were at income multiples of more than three times single or 2.75 times joint income. Today that proportion is less than 2 per cent. Clearly affordability has improved since the crunch and as a result so have the risks associated with mortgage lending. But there is still some overhang of risks from the loans taken out at the peak of the market.

The average house price between Q1 2007 and Q2 2008 was about £178,000, which means the average mortgage payment, on a fixed-rate loan at the time was just over £1,000 per month. At the end of a five-year fix that would have reverted to a variable rate, which by now would mean the mortgage payment would have fallen by about 20 per cent to £800 a month – a significant saving. But at the same time the fall in house prices means that there was not much improvement in the equity position. And if the theory that how wealthy consumers feel is also a signal of how much they are willing to spend, this could be another reason for the drag the level of housing debt is believed to have on the wider economic recovery.

The average house price, according to the HM Land Registry measure, is just over £171,000 today – still below the average for the 2007/8 pre-crunch period. Even taking into account the repayment of capital over the last seven years, the outstanding LTV ratio is still about 83 per cent – not that much improved on the starting position. From the lenders’ perspective, the reduction in payment risk as a result of the sharp cut in interest rates has been replaced by a higher potential loss given default because of the gradual erosion of the LTV ratio. That will make lenders more reluctant to loosen their criteria than they may otherwise have been to.

But even though the payment risk should be lower as a result of the cut in rates, it may not be any less of a burden to the particular household because over the last five years wages have actually fallen in real terms.

Investment

UK housing has traditionally been a good investment, especially when inflation has been high. At such times property prices rise, but debt levels stay the same. But more importantly, wages increase faster, so the debt burden also falls at a quicker rate. In high-inflation times, gearing up to borrow as much as you could to buy a property meant it was tough in the first couple of years, but the pain quickly subsided. When inflation is low (and wage growth even lower) that gearing up strategy looks less attractive.

Assuming a 95 per cent mortgage at 5 per cent on the average house price of £178,000, in the first year mortgage payments would take up over a fifth of gross income. With wage growth of 10 per cent – similar to wage growth in the 1980s – 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 2 per cent the burden hangs around a lot longer. Not only does that mean that paying off a mortgage feels harder for longer, but it also means that there is less money left over to trade up or spend on other things. This is one of the factors to which the UK market is still adjusting, and will continue to hinder house price growth. It is also a major concern to the Bank or England in how UK households’ level of indebtedness acts as a brake on consumption spending, and hence the pace at which the rest of the economy can recover.

Reasons

The Bank sets out three reasons high debt may have affected spending and the pace of recovery in the wider economy.

First, highly indebted households were disproportionately affected by tighter credit conditions. High existing debt levels caused lower spending by restricting borrowers’ ability to renew, or increase, existing debt, and by lowering expectations of future access to credit.

Secondly, highly indebted households may have become more concerned about their ability to make future repayments, and tightened their belts even more as a precautionary measure.

Lastly, highly indebted households may just taken out large volumes of debt in the booming years due to over-optimism about their future income, and are now struggling to get back on an even keel.

All this is explains why things may have taken longer than expected to pick up. But the better credit quality of lending over the last few years, and the expected erosion of the debt burden as the regulations bite, all mean that there should be a more secure basis for a sustainable and stable recovery in the new housing market cycle.

Fionnuala Earley is residential research director of Hamptons International

Key points

* The growth in debt is one reason why the Bank of England is concerned about the household sector today.

* The average house price between Q1 2007 and Q2 2008 was £178,000 – higher than it is today.

* The better credit quality of lending over the past few years means that there should be a more secure basis for a sustainable and stable recovery.