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24 July 2014

Too many households with modest means are shouldering too high a debt burden

As we anticipate interest rates rising, how can the government help households in debt through the painful transition?

By Gavin Kelly

Whether it is this autumn, the New Year or shortly after next May’s election, everyone knows that interest rates are going to start rising sometime relatively soon. Yet despite the endless “guess the month” speculation about the precise timing of the first rise, little thought has actually been given to the bigger and longer-term question of ensuring the right framework is in place to ease the painful transition back to more normal interest rates for Britain’s borrowers.

The nature of the debt challenge tends to get oversimplified. The mere fact that levels of debt in cash terms sound scarily high isn’t necessarily cause for panic. We’d expect, for instance, a gentle rise in house prices to generate a steady growth in household debt. No, the biggest problem is essentially a distributional one. Too many households with modest means are shouldering too high a debt burden. Today they are already struggling even with rock-bottom interest rates. Tomorrow they could be pushed over the edge – or that, at least, is the fear.  

To appreciate the extraordinary period we have lived through, consider that a household with a mortgage of £75k has received a cumulative ‘windfall’ of around £12.5k in the years since the crisis, relative to the cost of servicing the same mortgage before 2008 (double that for a mortgage of £150k).That’s a very big gain and – for many homeowners, as opposed to renters, has compensated for the squeeze in real incomes. Looking to the future, if interest rates rise in line with expectations, to around 3 per cent by 2018, and typical mortgage rates go up as a result by say 1.5 per cent (some might think this optimistic), it adds £1.5k to the annual costs of a £150k mortgage. If you assume sharper rate rises the figures get truly scary.

All of which would, you’d think, help focus minds.

Yet I haven’t heard a single politician talk about the issue and what, if anything, might be done to prepare for it. That the next parliament will be overshadowed by prolonged, if largely unspecified, fiscal austerity is now a ubiquitous point. That it could also be shaped by steady monetary tightening rarely gets explored.

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Given that this trajectory is near-inevitable, even if the pace and scale of rate increases are still up for grabs, how might policy-makers help cushion the burden of adjustment for debt-soaked households?

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It’s a vexed question as there are two potentially contradictory goals: prevent a future credit-fuelled boom while at the same time carefully defusing the economic and social problems caused by the last one. (Think of it as avoiding a hair of the dog recovery while nursing those suffering an almighty hangover back to full health). Both are vital: but take the wrong approach on the former and you take risks with the latter.         

Navigating a way through this requires deft policy. According to a new report from the Resolution Foundation, first and foremost we must get the sequencing right. The Governor of the Bank of England has – correctly and repeatedly – indicated that rates are unlikely to go up until household incomes are climbing. Contrary to the city analysts itching to find evidence of resurgent wage-pressures (at a time when earnings growth just fell to its lowest ever recorded level), let’s not get too trigger happy.

The worry is less the MPC’s stance and more that the measure of household incomes that the Bank relies on is misleading: it consistently overstates income growth compared to other more authorative measures. Indeed, it is alarming that our authorities rely on a measure which would have us believe that disposable incomes were flat during the downturn when, as we know, they fell. What’s more, it’s a measure that doesn’t tell us anything about how different parts of the income distribution are faring. Given the debt-challenge is intrinsically a distributional one this is a rather large blind-spot which needs sorting.  

Second, some households have got used to rock-bottom rates and will need to be jolted to prepare for what is to come. The remaining window of opportunity should be used to get exposed borrowers to review their finances, consider how they will adjust to higher repayments and whether they could switch to deals that will better protect them. The financial regulator, the FCA, should force all banks to engage with 2m potentially exposed borrowers, even though this will feel like an unwelcome intrusion for some individuals.

Third, consumer regulation needs strengthening. Large numbers of households are likely to be severely constrained in their capacity to switch to a better deal. These potential ‘mortgage prisoners’ may struggle to refinance given the tougher lending criteria that banks have been told to adopt meaning that they will have no option other than sitting, precariously, on their bank’s standard variable rate. Pre-crash, these borrowers were awash with offers; now they are shunned. Given the market is unlikely to work for them, for now at least, regulation needs to ensure that they get treated reasonably.  

Finally, in a world of higher rates and sluggish income growth for some, it will inevitably be the case that there will be a spike in the numbers of homeowners unable to meet their obligations. Repossession can be both traumatic and expensive (often shifting cost onto the housing benefit bill and piling up problems in the rental sector) so thought needs to be given to how to make it easier for households to stay in their homes while reducing their equity and their debts (a sort of ‘shared ownership’ in reverse). To this effect, the report sketches out something that might be dubbed ‘help not to be repossessed’, a programme likely to serve more of a social purpose in the years ahead than Help to Buy.

Emerging out of a massive debt-overhang in reasonable health requires carefully calibrated monetary policy backed up by sympathetic regulatory and welfare measures. At the moment we are hoping things are alright on the night.

The post-crisis era has taken us on a journey into the monetary unknown. As a highly indebted society we quickly became comfortable with extraordinarily low rates. That era is coming to an end: time to prepare for the journey back to normal.