A slew of financial journalists has been talking about a ‘mortgage time bomb’ in recent weeks. This comes as rising interest rates set by the Bank of England in response to inflation – well above its target level of 2% a year – are leading to higher mortgage interest rates and monthly mortgage payments for households and buy-to-let landlords.
With a total of £1.6 trillion borrowed as mortgages in the UK, the effect of interest rates going up is huge. Just last week, two-year fixed mortgage rates reached 6.7% – a level not seen since the global financial crisis of 2007-09.
How can we understand what is happening to mortgage rates?
Thinking the problem through like an economist helps to understand what is happening. Economists think in real or ‘inflation-adjusted’ terms, which is key to unpicking the misunderstandings that prevail in much of the media commentary on mortgage interest rates. Thinking in these terms also provides the answer to the problem of rising mortgage interest rates.
The key point is that mortgage contracts are specified in nominal terms and so do not take account of inflation. As a result, when we have higher inflation, the value of the outstanding mortgage is reduced directly by inflation.
With 10% inflation, this effect is substantial. For example, in real terms, a £200,000 mortgage will have fallen in value during 2022 by about 10%, or £20,000. In 2023, if inflation averages about 6%, the figure will be £12,000.
Thus, in the two-year period 2022-23, a mortgage worth £200,000 in 2021 will have fallen to £168,000 in 2021 prices. This will have happened just as a result of inflation, even if not a penny of the original capital has been repaid by the borrower (on an interest-only loan, for example).
Interest rates – including mortgage rates – are still below the rate of inflation. This may change but we are not there yet.
How do mortgages need to be adjusted to be inflation-neutral?
Interest rates consist of two parts: one is to compensate the lender for the declining value of the loan due to inflation; the other is the ‘real return’, or what Irvin Fisher called the real interest rate, which is the nominal rate minus the rate of inflation.
For example, if the inflation rate were 10%, then the mortgage interest rate would need to be 10% just to compensate the lender for the fall in the value of its loan due to inflation. A real interest rate of 2% would require a mortgage rate to be 12% – inflation plus the real rate.
Thus, when we look at the effect of inflation on mortgages, a ‘neutral’ interest rate, one that leaves the borrower and lender unaffected by inflation, is equal to the real rate plus inflation. Given that economists estimate that the equilibrium real rate is between 1-2%, a neutral mortgage interest rate would be at the level of inflation plus 1-2%.
But other factors beyond a neutral interest rate influence whether or not the mortgage contract is affected by inflation.
We also have the amount of the mortgage in nominal pounds. Even if the mortgage rate rises in line with inflation, there is a second very important effect of inflation: it speeds up the rate at which the mortgage is repaid in real terms.
To see this, consider the same mortgage in real terms and nominal terms, assuming that there is a zero-interest rate: the £200,000 mortgage is paid off at £5,000 per year over 40 years. Figure 1 shows time in years on the horizontal axis and the amount outstanding in terms of prices at time 0 on the left-hand vertical axis.
The blue line is what happens when there is zero inflation: the outstanding value of the mortgage simply declines in a straight line (£5,000 per year) to zero in year 40. With 5% inflation, we get the red line, which declines much faster and has a convex shape. The dashed grey line gives the ratio of the two, with the outstanding debt for 5% inflation as a percentage of the outstanding debt with no inflation, the percentage being given by the right-hand vertical axis.
The basic point is that with a fixed nominal mortgage, the higher the inflation rate, the faster the repayment in real terms.
Figure 1: Repayment after inflation
This brings us to the second way in which the mortgage needs to be adjusted to be inflation-neutral and to avoid the speeding up of repayment. The outstanding mortgage needs to be increased in nominal terms to keep the real value the same.
This is achieved by the borrower increasing the mortgage in line with inflation – in effect remortgaging in line with inflation. If the lender increases the mortgage in this way, both the borrower and lender have exactly the same profile of real assets and liabilities over time for any level of inflation.
If we combine the two elements needed for the mortgage to be inflation-neutral, the ‘first-best’ mortgage would follow two principles. First, the mortgage interest rate would be adjusted to maintain the agreed real return (the real interest rate plus inflation).
Second, the size of the mortgage in nominal terms would increase with inflation. In effect, the borrower increases the mortgage to pay off the increase on mortgage payments due to inflation. At the end of the year, by following this rule, the real value of the mortgage would be constant (for both the lender and borrower) and the real return would be the same for the lender.
What does this all look like in reality?
This is, of course, an imaginary ideal, and in practice there are potentially lots of problems in implementing it. Current mortgage contracts are very different and take no account of inflation at all. But from a policy point of view, knowing what an inflation-neutral mortgage would look like can help us to design a policy that can address the problem of rising interest rates.
If nothing is done, mortgage payments rise and the possibility of households missing payments and even having their homes repossessed or becoming homeless increases.
Mortgage lenders also suffer as their balance sheet is damaged by the ‘bad mortgages’. This is clearly a very bad outcome and totally unnecessary.
To avoid this, a policy of forbearance needs to be introduced by the government that will improve the situation for both borrowers and lenders.
Mortgage borrowers who find it difficult to meet increased mortgage payments should be offered a range of options by lenders. The general idea is that with inflation paying off part of the outstanding value of the mortgage in real terms, this leaves space for lenders to help out the borrowers with their cash flow.
What are possible solutions?
There are three possible ways that households could be offered support:
- Where there is equity in the property – that is, the current house price exceeds the mortgage – a simple fast-track remortgage (equity release) should be offered. This can be used to meet the increased mortgage payments in part, or even whole. This is a suitable solution for older mortgages with a low loan-to-value ratio. This mimics the inflation-neutral mortgage.
- So long as the inflation rate exceeds the mortgage rate, borrowers should be offered a suspension or reduction in capital repayments for a fixed period – for example, two years. In this case, a tapered return to full payments should be designed.
- In the longer run, even when inflation has returned to 2%, it is likely that the Bank of England will set rates in excess of inflation, probably averaging in the range 3-4%. That means that mortgage rates will be in the range 5-6% in the long run. For some households this will be difficult, and it may be necessary to come up with arrangements to help these households – for example, by extending the life of the mortgage.
Different options would suit different people. Nothing should be imposed on borrowers – if they choose to meet the higher payments and, in effect, speed up the repayment of their mortgages, they should be free to do so.
But the government should require mortgage lenders to offer a suitable range of options along the lines of the suggestions above (points one and two).
In reality, it will not be possible to save all households. For example, households that have just bought a house or which are in negative equity and have become unemployed might not be able to meet payments under normal circumstances with or without inflation.
Even in these cases, inflation improves matters in the longer run and so some households might be able to reach a solution from option two (above) that would not have been possible without the rise in inflation.
Once we understand that inflation makes mortgage borrowers better off, it also becomes apparent that giving direct help to borrowers in the form of some kind of mortgage interest relief from the Treasury is not only unnecessary, but also perverse. This would be giving money to people who are already being made better off by inflation.
Buy-to-let mortgages raise different issues, not least because they are sometimes interest-only to start with. It is beyond the scope of this article to deal with this in detail, but the same general principle applies: that the long-run financial position of buy-to-let landlords is improved by inflation.
The Chancellor Jeremy Hunt has just introduced a policy that is partly in line with this notion of forbearance. Households can switch temporarily to interest-only payments for a six-month period and repossessions are delayed for 12 months. Households can also increase the length of their mortgages.
This policy does not really show an appreciation of the underlying economic principles, and it should be extended for a longer time and allow for more options, as described above.
In the longer run, mortgage interest rates are likely to be higher than they were during the period of near-zero Bank of England policy rates, which was a historical anomaly. But the currently elevated inflation makes the situation better for mortgage holders, even with higher interest rates.
This is the most important insight that economists can provide to discussions of the mortgage time bomb. The solution to the problem is made more obvious once we look at the real inflation-adjusted world.
Where can I find out more?
Who are experts on this question?
- Jagjit Chadha
- Huw Dixon
- Michael McMahon
- Silvana Tenreyro
Author: Huw Dixon
Picture by Victor Huang on iStock