Given a tightening in credit conditions, the Financial Policy Committee is probably right to be unconcerned by the recent surge in mortgage lending. In fact, the Committee is preparing to loosen its mortgage lending guardrails, which may allow faster house price growth in the medium term.
- Given a tightening in credit conditions, the Financial Policy Committee (FPC) is probably right to be unconcerned by the recent surge in mortgage lending. In fact, the Committee is preparing to loosen its mortgage lending guardrails, which may allow faster house price growth in the medium term.
- A boom in mortgage lending is a classic sign of an emerging housing market bubble. (See here.) But the FPC has good reason to be unconcerned by the current surge in credit for two reasons. First, mortgage lending is still making up for lost time after its collapse in Q2. The 12-month sum of the value of mortgage approvals was still 9% below its pre-virus level in October.
- Second, the surge has come despite a tightening in credit conditions. For example, banks have reduced high loan-to-value (LTV) lending due to both the uncertain economic outlook, and to manage demand given ongoing capacity constraints in processing applications. (See here.)
- The fact that loosening credit conditions are not behind the surge in mortgage lending doesn’t mean that house prices will not drop next year. Job losses among existing borrowers will lead to an increase in arrears and repossessions, and the end of the stamp duty holiday will create a drop in demand. That said, it is a good reason to think that house prices will dip, rather than crash, in 2021. (See here.)
- Lending has also remained well within the FPC’s loan-to-income (LTI) ratio guardrails. The FPC’s “affordability test” stipulates that borrowers should be able to continue to service the mortgage were the interest rate to rise to the Standard Variable Rate (SVR) plus 3ppts. With SVRs currently about 3.6%, that caps the LTI ratio banks can offer to borrowers at about 4.9 times income on a 25-year loan. (See Chart 1.)
- At its December meeting, the FPC hinted that it will loosen its LTI guardrails next year given the “lower for longer” outlook for interest rates. When the affordability test was introduced in 2014, investors thought bank rate would have risen from 0.5% to 3% by now. So testing affordability against the SVR plus 300bps seemed reasonable. Now investors agree with us that bank rate is likely to be near zero for the next five years. (See Chart 2.)
- Lower mortgage rates mean that households can afford a mortgage that is a higher multiple of their income, and makes the current calibration of the affordability stress test look too severe. SVRs have fallen by about 70bps less than the average effective mortgage rate since 2014. To take account of this, the affordability test interest rate could change to the SVR plus 230bps. That would be consistent with the maximum LTI on a 25-year loan increasing to about 5.2. But the FPC pointed out that the likelihood of a large rise in rates now appears much smaller too, so it may loosen requirements further than this.
- As mortgage lending rules aren’t biting at present, a rule change would not have an immediate impact on mortgage lending or house prices. But by opening the door to mortgage lending at higher income multiples in the future, looser regulations could mean that house price growth turns out to be stronger than the increases of 2% to 3% per-year that we had pencilled in for 2023 and beyond. (See here.)
Chart 1: Interest Rate & LTI Ratio on a 25-year Mortgage
Chart 2: Bank Rate (%)
Sources: Capital Economics, BoE
Sources: Refinitiv, Capital Economics
Andrew Wishart, Property Economist, +44 (0)7427 682 411, email@example.com