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27 September 2022

Get ready for the next housing crisis: negative equity

As interest rates rise and mortgages become unaffordable, the whole system will start to crumble.

We often hear the refrain “the UK is not the US”. When it comes to a potential housing crisis, though, that doesn’t always work in the UK’s favour.

Because British banks hadn’t issued mortgages quite as excessive as the subprime loans handed out by US banks prior to the 2008 financial crisis, the UK didn’t have either the same scale of housing crash or nearly so many repossessions or foreclosures as America did. But there is one crucial difference between how British and American mortgages work that makes being unable to afford the loan on your home there – though still terrible – not quite so bad as here. In the US if you hand back the keys to your home to your lender, that’s it, it’s over. In the UK, if your home is worth less than the amount of debt you have at the point where it’s repossessed, you still owe the bank the outstanding amount. This is what’s known as negative equity, and it can leave people trapped in homes they can no longer afford, stuck with the dilemma of huge debt if they sell now or battling repossession if they can no longer afford their repayments.

The UK’s last major negative equity crisis happened in the early 1990s and was miserable for all concerned. However, it did lead to a substantial correction in house prices – something many younger people in the UK are desperately hoping for now. Sadly, there are reasons to think it will be much worse this time around – for virtually everyone.

The core of the issue is that the Bank of England is raising interest rates to try to deal with runaway inflation. That was already set to pose a challenge to people with mortgages, but the so-called emergency Budget last week has increased the risk to epic proportions – with the market now expecting the Bank of England to raise base interest rates to at least 6 per cent by the end of June 2023. At the start of June 2022, the base rate was just 1 per cent.

Ordinary people will feel this rise most acutely in their mortgage. Many mortgages are fixed for a period (usually two to five years), but once that runs out homeowners will find their rate is raised to about 1 percentage point above the Bank of England base rate. That will have a dramatic effect on their repayments.

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Someone with a standard repayment mortgage who is currently paying £700 a month at 2.25 per cent will see their payments rise to £970 if their rate hits 5 per cent and £1,200 if it hits 7 per cent (which would be the minimum rate expected if the Bank of England base rate hits 6 per cent).

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Some people, including most buy-to-let investors, have interest-only mortgages, which don’t involve repaying any of the actual capital in the house. These are even more dramatically affected by interest rate hikes: someone repaying £450 a month at 2.25 per cent will, for example, repay around £1,000 at 5 per cent.

If you can’t afford to keep up mortgage repayments the natural reaction is to try to sell the property, but that relies on the existence of buyers who are able to afford it. Given that other buyers relying on mortgages would need to pay the higher rates, that generally means prices will fall, exposing those trying to sell to the risk of negative equity.

Those arguing we shouldn’t be too worried about a negative equity crisis now because we survived it in the early 1990s should consider how different the housing landscape is today. For a start, homes are much more expensive versus incomes than they were in the housing boom of the late 1980s. At the 1988 peak London homes cost an average of 5.5 times the average salary. At the moment it’s 11 times salary, meaning the relative amount of negative equity is much harder to pay off with wages or consumer debt.

The government was also encouraging lending with deposits of just 5 per cent until as recently as last year, leaving homeowners – especially young people who have only recently got on the housing ladder – with only tiny amounts of equity before they are wiped out and trapped. The rise of shared ownership schemes similarly locks people into their mortgages. We are staring a full-blown crisis for owners in the face.

And if you think all this might be good for renters, think again. House prices might start to fall, but as it stands there are lots of overseas cash buyers who like investing in UK property, aren’t affected by interest rates, and just got a huge discount thanks to the falling pound. They will be far more able to take advantage of prices that are lower than they were but still higher than UK buyers reliant on a mortgage could afford.

Meanwhile, landlords facing losses on their buy-to-let will first try to hike prices and then try to sell up – often leading to a sitting tenant being evicted. Owner-occupiers abandoning their homes may move to the rental market, pushing up competition for rent. As with all market chaos, there will be winners and losers, but there are few reasons to believe it is renters looking to buy that will be among them.

We have spent much of the summer worrying about the cost of energy this winter, and with good cause. We now need to worry about both the cost and availability of housing, too. This could get bleak.

[See also: Has the Bank of England lost control?]