Britain's mortgage crunch returns

Two-year gilt yields have risen above five per cent because UK core inflation will not come down, and mortgage rates have followed them to levels last seen in the global financial crisis. For British borrowers, the years of barely noticeable interest bills ended abruptly. The Bank of England's rate rises are reaching the economy mainly through housing, and they are hitting hard.

Core inflation refuses to fall

The trigger was April's inflation report. Headline consumer price inflation fell to 8.7 per cent, less than markets had expected, while core inflation rose to 6.8 per cent, its highest since 1992. Wage figures published last week showed regular pay growing at a pace rarely seen outside the distortions of the pandemic. Markets now expect Bank Rate, already 4.5 per cent after twelve consecutive increases, to go well above 5 per cent, and the two-year yield has climbed past the peak it reached after last September's mini-budget. May's inflation figures arrive tomorrow, and the Monetary Policy Committee announces its decision on Thursday.

Britain's inflation rate is among the highest in the G7, and the reasons go beyond energy. A labour market left short of workers after the pandemic has pushed up pay in services, and services firms pass wage costs on to customers. That is the kind of inflation that feeds on itself, and it explains why markets have concluded that the Bank still has work to do.

Lenders price fixed-rate mortgages off swap rates, which move with gilt yields, so the repricing reached borrowers within days. Banks have withdrawn and relaunched products at higher rates, sometimes giving brokers only hours of notice. A mortgage offer typically lasts six months, which means the rates households are locking in now will set their payments well into the next few years.

Fixed for two years, then not

In America, thirty-year fixed loans protect existing borrowers from tighter policy. Britain relies on two- and five-year fixes. Millions of households are coming to the end of those deals and will see their monthly interest bills double or triple. Every extra pound paid to the lender comes straight out of disposable income, working much like a tax on consumption that nobody can hedge.

The arithmetic is simple. In 2021 the cheapest two-year fixes cost well under 2 per cent. For a borrower with a £200,000 loan, moving from a 2 per cent rate to a 6 per cent one lifts the annual interest bill from £4,000 to £12,000, before any repayment of capital. Five-year fixes taken out in 2018 are also rolling off, and those borrowers face smaller but still painful increases. The Bank sees the effect only gradually, because the shock arrives in waves as each cohort of fixes expires.

Borrowers facing that jump have few good options. Some will stretch the term of the loan, which lowers the monthly payment at the cost of paying interest for longer. Others will switch to interest-only terms for a period or drift onto their lender's standard variable rate, which is usually higher still. Each choice keeps the household current on its payments while leaving less to spend, so the damage shows up in the shops before it shows up in arrears.

Who pays and who gains

The squeeze is uneven. Outright owners, who in England outnumber households with a mortgage, gain from higher rates on their savings, as do older savers in general. Landlords refinancing buy-to-let loans will pass some of the cost on through rents or sell, so tenants feel it with a delay. The heaviest burden falls on younger households who bought recently at high prices with large loans relative to their incomes. Banks earn wider margins on deposits for now, but they face higher arrears if unemployment starts to rise.

Renters are already paying. Private rents are rising at the fastest pace in the official series, as landlords facing dearer finance leave the market or raise charges, and demand is swelled by would-be buyers who can no longer afford a mortgage. For tenants the Bank's tightening therefore arrives twice, once through rents and again through the higher cost of the deposit they are trying to save.

Lessons from 1990

Britain has been here before on a larger scale. When Bank Rate reached 15 per cent in 1989-90, most mortgages were on variable rates, and repossessions surged in the early 1990s as house prices fell. There are reasons for less alarm this time. Since 2014 lenders have been required to check whether borrowers could cope with higher rates, unemployment remains low, and many households built up savings during the pandemic. Those defences reduce the risk of forced sales. They do not stop money going to the bank instead of the shops, and the Bank's monthly lending figures and retailers' sales will show how quickly that shift is happening.

House prices are the other channel. The main lenders' indices show prices already falling on an annual basis, and higher mortgage rates cut the amount new buyers can borrow, which caps what sellers can ask. Falling prices do not hurt owners who stay put, but they erode the equity that lets borrowers remortgage on good terms, and they discourage the spending on moves, furniture and building work that normally follows a sale.

Because of how Britain finances its homes, each rate rise drains cash from households within months. Consumer spending will weaken well before the Bank sees core inflation fall, and by the end of the year the Bank is likely to find it has tightened into a slowdown it could not see in its own data.