Mortgage interest rates have risen in the UK. Three major factors account for this rise: The Truss-Kwarteng mini-budget; quantitative tightening; and short rates being pushed up in response to inflation. Although higher mortgage payments affect everyone, lower-income mortgage holders and first-time buyers are likely to be hit hardest. The decisions of these groups are likely to ripple throughout the rest of the housing market, playing a major role in determining how far house prices will ultimately fall.

By October 20, 2022, fixed-term mortgage rates had reached a 14-year high, with average two- and five-year fixed rates of 6.65% and 6.51%. As of November 3, 2022, variable rates had risen to 6.49% (compared with 3.59% in December 2021). Although rates have fallen slightly since, they remain high relative to what consumers have become used to.

There have been two causes of the rise in fixed rates: the September 23, 2022 mini-budget devised by then Prime Minister Liz Truss and then chancellor Kwasi Kwarteng, coupled with quantitative tightening. Gilt yields shot up in the wake of the Truss-Kwarteng mini-budget as demand for government debt plummeted. Gilt yields were already on the rise prior to this shock due to the Bank of England’s (BoE’s) efforts to reduce the size of its balance sheet by selling its own stock of gilts – a process referred to as quantitative tightening. The important thing to note here is that government bonds are a safe asset with a negligible risk of default. As such, banks are generally only willing to offer mortgages at rates above gilt yields so that they can price in the risk of default. Both of these factors have led to rising fixed-term interest rates.

Yet fixed rates are not the only source of disturbance. In response to rising inflation, the BoE has raised the overnight rate in the interbank market for liquidity. Importantly, this interest rate serves as the benchmark for other short rates in much the same way gilt yields serve as the benchmark for long rates. A rising overnight rate will have therefore directly raised the variable rate of interest on mortgages.

The groups that are going to be hit hardest by these rises are first-time buyers and lower-income homeowners. According to GlobalData’s 2022 Financial Services Consumer Survey, 1.7% of UK consumers are lower-income homeowners on a variable-rate mortgage, 2.4% are lower-income homeowners on a fixed-rate mortgage, and 2.7% are looking to buy their first home. Although these groups only represent a small section of society, the impact rate rises have on this subset has the potential to ripple throughout the rest of the economy. Reduced demand for housing from these groups will depress house prices, which could result in a feedback effect whereby house prices fall ever lower as lower-income homeowners either can no longer make mortgage payments or sell their property to avoid going into negative equity.

There are certain buffers that may limit the likelihood of this feedback loop taking hold. For example, up until August 2021, borrowers were asked to prove they could cope with a 3 percentage point rise in interest rates before they could be approved for a home loan. It is also likely that many consumers have been preparing for higher mortgage costs, as GlobalData’s UK Sentiment Tracker notes that UK consumers have been expecting rising rates for the last 12 months. Yet with a recession on the horizon and the BoE predicting that inflation will only stabilize at around 2% in Q3 2024, the cost-of-living crisis will most likely get worse. As it does, these buffers will waver and the fragility of the housing market will increase.

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A fall in house prices and a rise in variable rates in the UK over the coming year is therefore almost certain. The magnitude of this fall is hard to judge at this point, partly because inflation is being driven primarily by food prices – demand for which is fairly inelastic (meaning it does not change much when prices change). Compounding this uncertainty is quantitative tightening. The BoE has admitted it is unsure how much of an impact it will have on bond markets. Regardless of the specificities, it can be concluded with some certainty that the era of low interest mortgages is at an end.