According to the latest DBRS Morningstar mortgage market review, inflation will stress the income of borrowers in the short-term, especially those who are vulnerable, and this will feed into high borrowing costs and a possible cooling of mortgage demand.
However, it said a “historically low starting point for rates increase, limited housing supply, and tight labour market” should prevent “extreme deviations” in house prices and borrowers’ ability to pay mortgage debts.
The report continued that there had been a “clear improvement” in underwriting criteria following the global financial crisis and the introduction of the Mortgage Market Review in 2014.
It said the withdrawal of the interest rate stress test would have a “limited impact” as the loan to income flow limit remained in force.
It also said how inflation develops throughout the year would be the “key driver” of the UK’s mortgage market performance.
The report said the main inflation drivers in the UK were energy prices, particularly electricity and gas. It also noted that rising food and commodity prices due to the war in Ukraine had a factor.
DBRS Morningstar said the prospect of another Ofgem price cap increase in October suggested that Consumer Price Index inflation numbers were “lagging”, so inflation would most likely continue to rise.
It said there was a “high level of uncertainty” around the future of the economy, but in the short-term the cost of living would continue to outpace wage growth, which would lead to less disposable income for borrowers.
The tightening of rates by the Bank of England could also lead to an increase in the cost of borrowers’ debt, especially for those on variable rates.
“Nevertheless, it is important to take note that, not only the current labour market is particularly tight, but also that borrowers would likely prioritise other actions before being unable to service their debt, such as lifestyle changes, reducing discretionary spending, or reducing savings,” it explained.
The report added that house prices could see a “limited upside” as borrowers may be able to afford smaller mortgages.
However, it warned that in the medium term it expected wage increases to reflect cost of living rises and so longer term inflation could result in asset prices, such as housing.
It noted that the “structural shortage of housing supply” should limit rising property prices.
Affordability ratio shows ‘upward, long-term trend’
The report said affordability ratio data at a regional level showed an “upward, long-term trend” between median house prices and median gross annual earnings since 2010, and this was especially pronounced in London.
From 2002, the affordability ratio in the UK has risen from five times earnings to nine times earnings, and this has doubled in London from seven times to 14 times. The report said this had been driven by house price growth.
It said the London affordability ratio fell slightly between 2017 and 2020 as income growth outpaced house price inflation, while the opposite occurred in the country. The trend has since reversed due to rising house prices.
The report said loan to income data showed a similar trend as house price growth surpassed wage growth.
According to the report, the highest income multiple brackets – defined as four times income for a single borrower or above three times income for joint borrowers – had risen from accounting for 30 per cent of gross advances in 2007 to 50 per cent in 2021. Between 2020 and 2021, this bracket has increased by 3.6 per cent.
DBRS Morningstar said the evolution of interest rates over the past 10 years should be kept in mind when considering affordability, as significantly lower levels compared to pre-GFC allowed borrowing costs to be substantially cheaper.
Going forward, in an increasing rates scenario, DBRS Morningstar expects the highest income multiple bracket to reduce as borrowing costs rise and inflation gradually feeds in to wages while mortgage demand cools.
The report said lenders “should be better prepared to face the impact of an increasing interest rate environment on borrowers’ affordability”.
It pointed to responsible lending rules imposed in 2014 after the Mortgage Market Review, along with historically low level of interest rates, which meant borrowing costs for mortgage debt have “remained at a relatively low and stable share of households average weekly expenditures”.
The report said mortgage costs have averaged at 18 per cent for mortgage buyers between 2010 and 2021.
It added that those using more than 30 per cent of their income on a mortgage fell during this period.
Fixed rate mortgage demand shows competitiveness of UK market
DBRS Morningstar said fixed rates accounted for 94 per cent of total gross advances at the end of 2021, and this potentially points to an increasing borrowers’ demand for low, short-term, fixed-rate loans.
The share of interest-only loans has “remained constant” at around 20 per cent throughout the past five years, due to changes following the GFC.
The report said the weighted average between fixed and variable rates has been “quite pronounced” since 2019, falling from five per cent to around two per cent.
It said the switch to fixed rates showed the “competitiveness” of the UK mortgage market and terms were mainly concentrated on two and five-year periods.
The report said in the first quarter of this year, the proportion of mortgage loans at less than two per cent margin over the bank base rate was 85.5 per cent, up 14 per cent quarter-on-quarter.
It said that it had been falling since 2020 but had gone up over the past two quarters due to interest rate rises.
DBRS Morningstar said the effective interest rate of new origination with floating rates increased from 1.5 per cent in December 2021 to two per cent in April 2022. This represents a 44 basis point increase, which compares to a 24 basis point increase for the total of new mortgages.
However, it warned that rates were rising from a low level and that the impact on borrowers’ performance should “remain relatively contained”, so there would be “minor impacts” on the residential mortgage backed securities market if inflationary pressures are not exacerbated.
It said there was a low and decreasing level of arrears and possessions due to “tighter regulations, better underwriting criteria, and a stronger economic environment”.
