Why UK housing demand can recover despite high mortgage rates

• Two developments in borrower and lending behaviour mean that housing activity and prices can be higher than before the pandemic for any given mortgage rate. That’s why we expect housing transactions to recover to their pre-pandemic levels and house prices to reach new highs even though mortgage rates will remain higher over the next few years than before the pandemic.
• Housing activity and prices did not completely collapse despite the leap in mortgage rates from 1.3% in late 2021 to a peak of 5.9% in July 2023. This was partly due to a shift in the behaviour of borrowers that has further to run. And a more recent change in lenders’ behaviour could further support housing activity and prices despite our view that mortgage rates will only fall from 4.2% in May to just below 4.0% in 2027.  
• Starting with borrowers, many lengthened their mortgage terms to offset the rise in monthly mortgage payments caused by higher mortgage rates. This has been going on for a while with the average term of mortgages taken out by first-time buyers (FTB) having risen from 25 years in 2005 to 29 years in 2021. But it has been supercharged since mortgage rates surged late in 2021 with the average term rising to 31 years in Q1 2025. That’s largely due to a big rise in the share of new mortgages issued with terms of 40 years or more. (See Chart 1.) If the increase in the average mortgage term over the past 20 years were to continue at the same pace, the average FTB mortgage term could rise to around 32 years by 2027.

• This has supported both housing demand and prices. To illustrate this, we consider the case of someone buying the average priced house (£272,000 in May) with a 20% deposit (£54,400) and an 80% loan (£217,600) at May’s new quoted mortgage rate of 4.23%. With a traditional 25-year term, their monthly mortgage payment would be £1,176. If they couldn’t afford that, then in the past they wouldn’t be able to buy the average priced house. But with a 31-year term, their monthly mortgage payment would be £1,051. Longer terms therefore increase demand by enabling more buyers to afford their monthly mortgage payments.
• Longer terms also increase prices if some buyers decide to increase the size of their loan and they are able to meet the other qualifying criteria for a bigger loan. For example, consider a buyer who could afford monthly mortgage payments of £1,176 on a 25-year term. They could raise the size of the loan by £25,900 (11.9%) from £217,600 to £243,500 as a 31-year term would also result in monthly mortgage payments of £1,176. If the house price remained at £272,000, the deposit could be reduced by £25,900 to £28,500. That would be a further boost to demand by enabling some people with a smaller deposit to buy. But if the buyer decided to keep the deposit at £54,400, the bigger loan of £243,500 could be used to buy a house with a price of £297,900, which is £25,900 (9.5%) higher than before.
• In reality, the direct boost to prices will have been smaller as many buyers will have used longer terms to reduce their monthly mortgage payments rather than to raise the size of the loan. That said, there would have been some indirect support to prices from demand being higher. And a further rise in mortgage terms, which seems likely, will probably continue to support demand and prices for any given mortgage rate. For example, if the average mortgage term rose from 31 years now to 32 years in 2027, the direct boost to prices could be worth up to 1.25%. (Using the same average price, loan and mortgage rate as above but with a 31-year term results in monthly mortgage payments of £1,051. With a 32-year term, a £3,400 increase in the loan and purchase price higher would deliver the same monthly mortgage payment.)
• The more recent change is that lenders are becoming more willing to loosen their lending criteria. In January, in response to the Chancellor’s push to boost economic growth, the Financial Conduct Authority suggested that mortgage lenders could build in more “flexibility” when assessing how future interest rate rises could influence a borrower’s mortgage payments (i.e. the “stress test”) rather than being required to stress test borrowers at the Standard Variable Rate plus 1.00%. In response, all of the big six mortgage lenders, which according to UK Finance account for about three quarters of the UK mortgage market, have reduced their stress test mortgage rates.
• This will also support housing demand. Using the same example as before for a 31-year term (a house price of £272,000, a 20% deposit of £54,400, an 80% loan of £217,600 and a mortgage rate of 4.23%), the monthly mortgage payment would be £1,051. Previously, lenders would have approved the mortgage if the borrower could afford a monthly mortgage payment of £1,607 (i.e. the Standard Variable Rate of around 7.15% plus 1.00% = 8.15%). But if lenders, for example, reduced the stress test to the Standard Variable Rate of 7.15%, that would mean the mortgage would be approved if the borrower could afford a monthly mortgage payment of £1,456. This loosening in lending criteria therefore boosts demand as more potential buyers pass the more lenient stress test.
• Again, it could also boost prices. Some buyers would have already passed the stress test at 8.15% by being able to demonstrate they could afford monthly mortgage payments of £1,607. That means they could also pass the stress test of 7.15% if they increased the size of the loan by £22,500 (10.3%) to £240,100. Again, that could boost demand if the borrower chose to use the bigger loan to reduce their deposit. But if they chose to keep the deposit the same and fully utilise all of their increased borrowing capacity, the house price could increase by £22,500 (8.3%) to £294,500. In other words, a loosening in the stress tests by 1 percentage point could directly boost the average house price by up to 8.3%.
• Once again, the actual boost will be smaller as some buyers may choose to reduce their monthly mortgage payments and/or deposit rather than increasing the loan size. And other lending constraints, such as loan-to-income thresholds, could prevent buyers from borrowing more.
• Overall, the increase in mortgage terms and looser lending standards has led to a shift in the relationship between housing transactions/prices and mortgage rates that probably has a bit further to run. That’s why we think the number of housing transactions can recover to their pre-pandemic monthly average of around 100,000 and house prices can rise by about 4% a year on average over 2025-27 even though mortgage rates won’t fall back to the pre-pandemic lows of below 2%. (See Chart 2.) Clients can explore and download all our UK housing forecasts in our interactive data dashboard.)

Ashley Webb, UK Economist, +(0)20 8146 2440, ashley.webb@capitaleconomics.com