Fergus Cumming and Danny Walker

Bank Rate has risen by more than 5 percentage points in the UK over the past couple of years. This has led to much higher mortgage rates for many people. In this post we analyse another potential source of pressure on mortgagors: the potential for falls in house prices to push borrowers into higher – and therefore more expensive – loan to value (LTV) bands. In a scenario where house prices fall by 10% and high LTV spreads rise by 100 basis points, we estimate that an additional 350,000 mortgagors could be pushed above an LTV of 75%, which could increase their annual repayments by an extra £2,000 on average. This could have a material impact on the economy.

There is significant public and media attention on how the Bank of England’s interest rate decisions affect mortgagors. The interest rates set by central banks are of course a key determinant of the rates people pay on their mortgages. Banks tend to price mortgages off interest rate swaps, which reflect the market’s expectations of future policy rates. The relevant swap rates for the 80% of UK mortgages that have fixed interest rates are typically the two and five-year rates. While Bank Rate has risen by more than 5 percentage points since December 2021, the two-year swap rate has risen by 4.6 percentage points and two-year mortgage rates have risen by around 4.5 percentage points (Chart 1). But Bank Rate is not the only determinant of mortgage rates.

Chart 1: Mortgage rates have increased sharply in the UK – they tend to be priced off swap rates, which are linked to Bank Rate

Note: The chart shows quoted rates for two-year mortgages at different LTV ratio bands. It compares them to Bank Rate (the Bank of England policy rate) and the two-year swap rate, both of which are considered risk-free rates.

Source: Bank of England.

Mortgages with lower deposits – higher LTV ratios – have higher interest rates, but the spread is currently very low

Loosely speaking, a mortgage interest rate is made up of the risk-free rate – typically the relevant swap rate – and some compensation for risk, known as the spread. LTV ratios are the key determinant of spreads. For example, someone with a deposit of at least 25% of the value of the house at the point the mortgage is issued qualifies for a 75% LTV mortgage, which comes with a lower interest rate than if they only had a deposit worth 10% of the value. Mortgages with higher deposits, and therefore lower LTVs, are generally safer for banks because higher deposits means borrowers can withstand larger house price falls before falling into negative equity. Higher LTV mortgages tend to have higher interest rates for that reason.

Throughout the 2010s it was common for the spread between 90% and 75% LTV mortgage rates to be between 1 and 2 percentage points (Chart 1). As of August 2023, that spread was less than 0.4 percentage points. In fact, spreads have been very narrow since 2021 and the last time spreads were at today’s levels was probably in 2008, which is before the official data began. Given that high LTV mortgages look relatively cheap compared with recent history, we construct an illustrative scenario where the 90% LTV spread returns to close to its post-2010 average – something we regard as plausible.

We analyse an illustrative scenario where mortgage spreads rise by 100 basis points and house prices fall by 10% from their peak

Our aim is not to forecast what will happen in the mortgage market, but simply to examine a set of conditions that are within the realms of possibility. We use data on the universe of UK owner-occupier mortgages in the Product Sales Database. The most detailed information is recorded when mortgages are originated for the first time and upon remortgage. We build a snapshot of the mortgage market by modelling how much principal people have paid down since origination and how house prices have evolved in their region. We focus on mortgages originated since 2020 Q4 because they are most likely to have high LTV ratios, given the borrowers have not had much time to pay down principal and have had less time to benefit from significant house price increases.

In our scenario analysis, the 90% LTV mortgage rate increases by 100 basis points (Chart 2) and house prices fall by 10% (Chart 3). As a comparison, in the 2007 to 2009 financial crisis, the 90% LTV spread – measured versus 60% LTV mortgages – reached over 250 basis points and house prices fell by almost 20% from peak to trough.

Chart 2: In our scenario analysis, the interest rates on mortgages with LTV ratios of above 75% increase by 100 basis points, taking them closer to historical spreads

Note: The chart shows quoted rates for two-year mortgages at different LTV bands, expressed as a spread versus the 0%–60% LTV rate. We analyse an indicative scenario where the spread on 75%–90%, 90%–100% and 100%+ LTV mortgages rises by 100 basis points.

Source: Bank of England.

We recalculate LTVs following the 10% fall in house prices in the scenario and assume all mortgagors eventually have to refinance at the new higher rate for their LTV band. In the real world, mortgagors reaching the end of their fixed term will face a recalculation of their LTV based on a revaluation of their house, which is typically calculated using private sector indices. As it happens, those indices have already fallen by a few per cent more than the official price index shown on Chart 3. We do not model mortgage choice in the scenario: for simplicity we assume that mortgagors take out a two-year fixed-rate mortgage.

Chart 3: In our scenario analysis, UK average house prices fall by 10%, taking them back to around their 2021 level

Note: The chart shows the UK house price index expressed as a percentage change since the start of 2010. We analyse an indicative scenario where the index falls by 10%.

Sources: Bank of England and Office for National Statistics.

The scenario pushes an additional 350,000 mortgagors above 75% LTV, increasing their annual repayments by £2,000 on average

At origination, around 40% of recent mortgages had deposits that were too small to be eligible for a 0%–60% or 60%–75% LTV mortgage. When we take account of principal repayments and house price growth since origination, that suggests around a quarter of recent mortgages – just under 800,000 – are above that 75% LTV threshold now.

We find that the house price fall in our scenario pushes an additional 350,000 mortgagors above the 75% LTV threshold, taking the total back to around 40% of recent mortgagors (Chart 4), or 1.1 million. It also pushes around 3% into negative equity. The assumed 100 basis point increase in mortgage spreads in the scenario leads to an average increase in annual repayments for these mortgagors of just over £2,000 by the time they refinance, over and above the impact from the increase in swap-rates. That is clearly a material impact for the people affected, but is it material for the economy?

Chart 4: The scenario leads to a rise in LTV ratios for recent mortgagors, which comes with higher interest rates

Note: The chart shows all UK owner-occupier mortgages in the Product Sales Database originated since 2020 Q4, split by LTV ratio. We update the loan amount outstanding by modelling the scheduled flow of principal repayments for each loan. We update the house price based on an assumption that house prices have evolved in line with the average price in their region (eg London, South East of England etc). The scenario reduces prices uniformly by 10%. We assume for simplicity that there are no 80% LTV products. The numbers should be interpreted as indicative rather than a precise read on the stock of UK mortgages.

Sources: Bank of England and Financial Conduct Authority Product Sales Database.

The macro impact of this scenario could be material, given that it affects those mortgagors that are most financially constrained

At first glance, the impact of this scenario looks relatively modest in comparison to the increase in Bank Rate that has already occurred. The 100 basis point increase in mortgage spreads in our scenario is less than a quarter of the size of the rise in swap rates that has already occurred. It also only affects 40% of recent mortgagors, and just over 10% of all mortgagors. Focusing on recent mortgagors, our analysis suggests that their aggregate additional repayment burden (£2.4 billion) amounts to around 20% of the total repayment increase caused by the rise in Bank rate on its own (£11 billion).

But it is also true that the mortgagors impacted by this scenario are some of the most financially constrained households, and some of the most important for policymakers to consider. Well-established theoretical research has emphasised the role of heterogeneity in macroeconomics and empirical research has previously explored the importance of the most levered mortgagors in the transmission of monetary policy. To the extent that the scenario affects households most likely to substantially change their spending patterns, it is plausible that this amplification channel is not trivial. Indeed, for the most levered mortgagors, the scenario eventually increases repayments by 40% over-and-above the rise in mortgage rates already baked in.

Implications

Policymakers across the globe are well versed in the importance of the housing and mortgage markets, particularly for monetary policy transmission. The financial crisis is still in the rear-view mirror and much has been learned from it. But this post highlights an interesting channel of monetary policy which, while it will be captured implicitly in some models, is often less discussed outside policy circles. The scenario analysis reminds us that there can be more to monetary policy tightening than risk-free rates. Many people expect the tightening that has already occurred to lead to a significant fall in house prices, and it is plausible that mortgage spreads will return to historical levels. Although there is uncertainty, this has the potential to lead to a material impact on economic activity over and above the impact of risk-free rates.

Fergus Cumming is Deputy Chief Economist at the Foreign, Commonwealth and Development Office. He used to work on monetary policy and financial stability at the Bank. Danny Walker works in the Bank’s Deputy Governor’s office.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

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