Will mortgage borrowers cope when the BoE hikes?
Speculation on the timing of the Bank of England’s first post-pandemic rate hike has been rife. But whether the BoE hikes rates later this week, next month or even waits until after year-end, it is worth thinking about what it will mean for the general public, a step away from the financial markets.
There have already been numerous headlines in the popular press about how much rate hikes might cost mortgage borrowers, with the general theme questioning whether the BoE should postpone or avoid hiking so as not to cause financial stress for these borrowers. Higher rates will of course lead to higher mortgage borrowing costs in the medium term, but around 80% of borrowers in the UK now have some form of fixed rate mortgage, giving them protection from rate rises in the near future and time to plan for the longer term.
Only those remaining borrowers who either deliberately chose a floating rate mortgage, or those who have allowed their fixed rate to expire and their loan to fall onto the Standard Variable Rate (“SVR”) or another floating rate, will see the immediate effect of higher borrowing rates. Many of the latter will be seasoned borrowers – possibly even from before the global financial crisis – who have benefitted tremendously from the lower rates in the meantime.
It is also worth remembering that rates were reduced to today’s extremely low levels as a direct reaction to the outbreak of the pandemic. In February last year the UK’s base rate was 0.75%, a full 65bp higher than it is today, and it had already been at that level for 18 months. At that time the general view was that rates would continue to “normalise” into the future, with no particular concern that this would impact mortgage borrower performance or introduce financial stress.
For those borrowers that are on floating rates, what is the impact likely to be? The first hike, when it comes, is expected to be a reversal of the 15bp reduction the BoE implemented in March 2020, which would take the base rate from 0.10% back to 0.25%. On a £250,000 interest-only loan, an increase in the BoE rate of 15bp would increase a borrower’s monthly instalment by £31 per month. A further 25bp at some point later next year would add another £52 to a borrower’s monthly costs.
Of course, this applies only to the 20% of borrowers who have floating rate mortgages, and many of those borrowers tend to have much smaller, older loans. In fact, the average mortgage size in the UK is around £135,000. For more recently originated loans (i.e. those made since the global financial crisis) banks have been under strict guidelines from the regulators to apply affordability stresses to loans when they underwrite them. For shorter dated fixed rate loans, lenders have been assessing an applicant’s ability to repay a mortgage on the basis of a stressed rate some 3% higher than the lender’s SVR. This buffer was chosen specifically to avoid the temptation for borrowers to overextend themselves in the low interest rate environment that has endured for the last decade or so, and thus be unable to afford repayments should rates subsequently rise. These strict lending guidelines should ensure that for borrowers on floating rates today, any increase in the near term remains affordable.
For borrowers on fixed rates, they have some time to assess their options. Recent headlines have also pointed to banks starting to push up rates for new loans and for those looking to refix their mortgages, and indeed banks have been doing this in reaction to the recent rise in market swap rates which they use to hedge their mortgage books. We would note however that even with rate rises on the way, mortgage rates today are still cheaper than they were both two years ago and five years ago (for those borrowers with existing typical two-year and five-year fixed period loans that are approaching the end of their fixed rate periods). So if these borrowers wait until the end of their original fixed rate periods (as many tend to), they may have to pay more than if they were able to refinance today, but there is every likelihood that their new loan will be at least as cheap as it was when they initially fixed the current period.
We do expect (and to a certain extent welcome) a return to normality with a period of controlled interest rates rises from the BoE as it aims to pick the right moments to react to the evolution of macro conditions, be it inflation, unemployment, economic growth or other factors. However, we also believe that any increase in rates will be well within the ability of the vast majority of mortgage borrowers to withstand, and we don’t foresee any particular increased financial stress flowing through and causing visible negative performance in mortgage books. That goes both for mortgage books on banks’ balance sheets and for those in the capital markets backing the £135bn of deals currently outstanding in the UK RMBS market.