Personal Investing
Ed Monk 4 Oct 2017 05:14pm

Four reasons why house prices are vulnerable

The reality of rising rates will come as a shock to today’s borrowers

UK house prices corrected sharply after the financial crisis struck ten years ago, but have been relatively untroubled since then.

Barring a blip in 2011, annual average house price growth has been positive since November 2009, according to the Office for National Statistics, and has peaked above 10% a year in that time.

The most recent data, however, has been weaker and, with interest rate rises at the Bank of England now seemingly closer than ever, a key test for property prices lies ahead.

An optimistic view is that normalising interest rates is itself a sign of a more healthy economy, which in turn will be positive for property prices in the long run. Additionally, rate rises are expected to be gradual, with the ultimate destination for the bank rate likely to be permanently lower than the historical average.

There are reasons to think, however, that the reaction in the property market may be more negative than some predict. Here are four of them.

Because borrowers aren’t used to rising rates

The last time UK mortgage borrowers experienced a rise in the bank rate was July 2007.

At that moment, those with tracker mortgages or loans pegged to their lender’s standard variable rate will have experienced an immediate rise in their monthly outgoings. Those with fixed-rate deals will have been protected for a period, but will have had to plan for a more expensive deal in the future.

This sort of uncertainty is what owning a house with a mortgage meant before 2007.

The uncertainty, however, turned out to be short-lived because just five months after that last rise the bank rate began to fall again. And it kept falling until March 2009, where it sat at a then low of 0.5% until August last year when Brexit uncertainty triggered yet another quarter point cut to 0.25%.

That’s more than ten years in which homeowners have not had to cope with the uncertainty and extra cost of rising mortgage repayments. What happens when they do?

Part of the recent resilience of the UK property market is the near-certainty that buyer’s will not see their monthly costs rise, giving them the confidence to stretch themselves in order to buy.

Sentiment is vital to any market and introducing downside uncertainty to buyers who have been used to only upside could see sentiment turn sharply negative.

Because of changes to mortgage lending rules

A big overhaul in how mortgages are granted since the credit crunch and financial crisis mean that higher interest rates automatically lower the sums house buyers can borrow.

Once upon a time, mortgage lending was remarkably (recklessly?) simple. Buyers could rely on being able to borrower a set multiple of their annual earnings.

A couple might, for example, be able to borrow three and a half time their joint salary. If that number was, say, £250,000 it would stay at £250,000 irrespective of changes in interest rates, so a rise in the bank rate would not immediately impact their ability to borrow.

This all changed in 2014 when new rules required banks to establish much more thoroughly what a borrower could afford, taking into account all their monthly income and outgoings. The sums they can borrow is now more dependent on what they can afford each month, rather than their overall level of pay.

A rise in rates increases the monthly cost of a mortgage, so automatically pushes the amount that can be borrowed downwards in a way that didn’t happen before.

Because maths

Part of the reason mortgage borrowers will feel a bigger hit from a rise in rates now comes down to simple mathematics.

According to Moneyfacts, the financial data provider, the average 2-year fixed rate mortgage in 2007 charged 6.45%. The average today is 2.22%.

Therefore, a quarter point rise in mortgage rates makes more difference to borrowers now than it did then.

Because of the decline of buy-to-let

Another key difference between now and the last time borrowers had to deal with rising rates is the role that buy-to-let landlords play in the property market.

Back in 2007, buy-to-let was exploding with many private individuals aspiring to own second (or third, or fourth) properties to let out. These buy-to-letters would often compete with first time buyers for urban one and two-bed flats, and drive up prices across the whole market as a result.

Latterly, tax changes have made it far harder for landlords to make buy-to-let work. There are higher rates of stamp duty to buy second properties and the tax-relief used to mean landlords could offset their mortgage interest against income tax has been made far less generous.

With higher rates limiting what first-time buyers can afford, there is less likely to be a landlord waiting to pick up the slack.

All these factors point to weakness in the property market. Notwithstanding instances of negative equity, this need not harm homeowners because it makes their next purchase cheaper. Borrowing to invest in property, however, looks a less certain bet that ever.

Ed Monk, Fidelity Personal Investing

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