Higher interest rates mean more expensive mortgages
IF THE ECONOMY is a machine, then monetary policy makers are engineers behind the scenes. On November 4, they kept the Bank of England’s interest rate at 0.1%, but appear to be set to change it up soon. Investors expect the rate to exceed 1% by the end of 2022, the steepest escalation since 2006. But as techies tinker, they face enormous uncertainty.
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Rising interest rates make saving more lucrative and borrowing more expensive. They can lower asset values, consumer spending and business investment, and cause the pound to appreciate. More directly, they can also increase mortgage payments, leaving households with less money to spend on other things. Unraveling these effects is tricky. A study published in 2019 on British and American households between the years 1970 and 2000, by James Cloyne of the University of California at Davis, Clodomiro Ferreira of the Bank of Spain and Paolo Surico of the London Business School, found that mortgage payments increased in response to higher official rates. But British spending in other areas fell nearly four times as much, showing that the indirect effects of monetary policy were also at work.
The same study found that the number of households with mortgages is very large: homeowner spending barely reacted to changes in official interest rates. Mortgage terms matter too. Historically, Britain was a nation of variable rate mortgages, with payments rising and falling with the official interest rate. In America, however, mortgage interest rates are generally fixed for decades. This helps explain why UK mortgage interest payments were almost three times more responsive to changes in official interest rates after four years than US payments.
Today’s monetary policy makers face a very different mortgage market than they did 15 years ago. In mid-2006, around 46% of Britons were living in a house with an outstanding mortgage; now only about 37% do. This change was brought about by the aging of the population, which means more homeowners have paid off their mortgages, and by an increase in the average age of first-time buyers. The share of Britons living in owned accommodation has increased from 25% in 2006 to 29% this year.
In addition, variable rate mortgages represented more than half of the stock in 2006, and more than 70% at the start of the 2010s. This share is now less than 20% (see graph). Fixed rate terms have grown longer and, since mid-2020, the majority of fixed rate mortgages have been fixed for five years. According to the figures of UK The finance industry group, fixed rate mortgages have relatively large outstanding balances, which means that homeowners who would suffer the most from higher interest rates are the most likely to be protected from them, at least to short term.
This leaves first-time buyers and people to refinance their mortgages. Regulatory changes aimed at ensuring financial accessibility have forced them, since 2014, to demonstrate that they can cope with an increase of three percentage points within five years of taking out a loan. If the main policy rate increases, according to Neal Hudson of BuiltPlace, a consultancy firm, pressure could be exerted to weaken this test to avoid excluding first-time buyers. This would reduce the pressure on credit associated with higher official rates.
The Bank of England seems confident that interest rate hikes will have a lot of punch, for example by influencing corporate credit. Its strategy of raising interest rates before unwinding the asset purchases with which it first fought the global financial crisis and then the effects of covid-19 results in part from its confidence that it understands the effects of the crisis. first. A 2019 analysis of its forecast by Innes McFee of Oxford Economics, another consultancy, suggested the bank believed interest rate hikes after 2017 would have a bigger effect on GDP only in the 2000s. (Mr McFee disagreed.) The UK economy does not have an instruction manual. Here is hoping that nothing breaks. ■
This article appeared in the Great Britain section of the print edition under the title “Raising the roof”