- Mortgage fixes in the UK are short by international standards
- IMF economists warn that the higher interests are, the greater the chance that households will feel the pinch
When interest rates started rising, two things seemed like a safe bet. First, higher rates would lead to an economic slowdown and, second, it would burst the post-pandemic housing bubble.
Neither scenario has really materialised – at least not in the UK. Despite the highest interest rates for 16 years, the economy is recovering from a very mild technical recession and house prices have only dipped. As the chart below shows, although some countries have seen a painful post-pandemic house price correction, the UK is not one of them. Mortgages could hold the key to understanding both economic puzzles.
How fixed-rate mortgages protect households
Mortgages should act as a powerful interest rate transmission mechanism. They are the biggest debt for households, and (for many) housing is the most significant form of wealth. As central bankers increase the base rate, households’ mortgage repayments will rise. This reduces disposable income – and consumer spending, too.
The theory is neat, but the reality looks far messier once you dig into the intricacies of mortgage markets. Although households on tracker mortgages see repayments leap when the base rate rises, those on fixed-rate mortgages see no immediate difference. In countries such as South Africa, the pass-through from higher interest rates is rapid (see chart below). The UK housing market, where 85 per cent of households have a fixed-rate deal, has been far better insulated.
A closer look at mortgage terms reveals even more nuance. In the US, 15 and 30-year deals are commonplace, with households often fixing for the entire duration of the mortgage term. In the UK, shorter two and five-year fixes are the norm – offering a far more short-term form of protection in a climate of rising interest rates.
Why higher mortgage rates could still bite
According to data from Fitch Ratings, £165bn of UK mortgages will expire in 2024 – a substantial amount, although down from £200bn in 2023. In 2025, a further £100bn-worth of deals will expire.
If forecasts are right, interest rates should be lower by then. But for many, new deals will still be far higher than rates secured before the start of this tightening cycle. Market expectations imply that two-year fixed-rate mortgage interest rates will fall to just 4.4 per cent by the year-end. In November 2021, the average rate on a newly drawn mortgage was just 1.5 per cent.
This means that the threat of a mortgage ‘timebomb’ has not gone away. Last month, IMF economists warned that as these shorter-term deals expire, “monetary policy transmission could suddenly become more effective”. They said that “the longer… rates are kept high, the greater the likelihood that households feel the pinch, even where they have so far been relatively sheltered”, warning central bankers against erring on the side of “too much tightening”.
Why rate cuts might not deliver much of a housing market boost
With rate cuts on the horizon, it is worth considering that they will have a limited impact on the way down. After all, households that entered new fixed-rate deals over the past 12 months will have done so at close to peak interest rates, and will be ‘locked in’ to these more expensive deals for the next few years.
Matters are complicated further by the non-linear relationship between the policy rate and mortgage rates. Although central bankers have held the base rate constant since last August, mortgage rates have ticked up throughout 2024 as rate cut expectations recalibrated. Economists at Pantheon Macroeconomics now expect mortgage rates to increase again, slowing house price inflation in the medium term.
Long-range forecasts imply that rate cuts will have a limited impact on house price growth. Analysts at Fitch Ratings expect ‘stable’ house prices (in other words, no growth) throughout 2024, while Pantheon economists expect an increase of less than 2 per cent. Steep interest rate hikes had a limited effect on the housing market – and there is reason to expect that cautious cuts will have an even milder impact.
