Why fixed-rate mortgage holders will be the worst hit by rising rates
Just hours after the Bank of England announced a 0.25 percentage point increase in the base rate, Nationwide Building Society said it will cut some of its fixed-rate deals by up to 0.45 percentage points.
As of Friday, the lender will offer a five-year fixed rate at 3.94pc – the lowest on the market – for borrowers remortgaging with a 40pc deposit.
This is because lenders price fixed-rate deals based on expectations of future borrowing costs: it is now feasible that Thursday's interest rate rise may have been the Bank’s last. The UK is certainly close to a peak in rates.
Recent turmoil in financial markets has also triggered a drop in swap rates, another gauge for future borrowing costs.
On the surface, this looks like good news for the housing market. But its woes are only just beginning.
“We are at the stage where a lot of people will be thinking, oh that’s it, the risks are kind of gone. But actually this is almost the most dangerous part of the process,” says Neal Hudson, of BuiltPlace analysts.
“Housing downturns start slowly, and then they speed up. The difficulty right now is that we are kind of moving into the second stage of this all. We are moving beyond the point where it’s just about interest rates. Now we are in the difficult bit, where things start to go wrong.”
The collapse of Silicon Valley Bank this month was the first signal of the slow, heavy toll of central bank rate rises. The cumulative effect of the Bank of England’s 11 consecutive rate rises are only just working their way through the system.
“We’re starting to find out where the fragility is in the domestic and global economy. but knowing exactly where these things are can be tricky. The danger is on the fringes of the financial system relating to the housing market. There are loads and loads of pockets of risk,” adds Hudson.
The UK’s buy-to-let sector is number one. Buy-to-let lenders use more wholesale funding than deposits, which means they are a little more exposed to interest rate rises than mainstream lenders, says Andrew Wishart, senior economist at Capital Economics. But there is little sign of weakness here yet.
“They are passing through rate increases on loans secured against assets that have only dropped in price by 3pc or 4pc following an increase of about 20pc over the past two years,” he adds.
Instead, it is landlords themselves who pose a threat to their lenders. “If there is going to be an issue with mortgage lenders I suspect it will stem from credit risk – mortgages going into arrears – and solvency rather than liquidity,” says Wishart.
The big risk for the buy-to-let sector is that landlords will see their profit margins eroded by rate rises when they refinance, pushing them into mortgage arrears or forcing them to sell up.
There are just over two million outstanding buy-to-let mortgages, according to UK Finance, a lender body. The vast majority of these are interest-only, meaning borrowers have not been making capital repayments.
Since February 2022, the average rate on a two-year, fixed-rate buy-to-let mortgage has jumped from 2.9pc to 5.81pc, according to Moneyfacts, a data company.
For a landlord remortgaging with a £150,000 loan, this difference in rates will cost them an extra £4,365 a year.
Changes to tax relief on buy-to-let mortgages, which mean that landlords who own properties in their own names can no longer offset all of their interest costs against their tax bills, are magnifying the blow of higher rates.
Landlords still have to pay the same amount of tax even if their properties make a loss. Capital Economics estimates that 365,000 landlords will be in this boat by the end of 2023 as their fixed-rate deals expire.
Partly in response to these tax changes, the buy-to-let sector has been becoming more corporate: smaller landlords are selling up, and their properties have been bought by larger landlords and held in company structures.
“The sector has become more concentrated,” says Hudson. “The danger there is, we know this from the financial crisis, if one loan in an investor’s portfolio goes bad then it can quite quickly spread across their entire portfolio, and perhaps to their primary residence. There is a risk that you see that snowballing.”
These landlords could then be pushed to sell, bringing a rush of supply in concentrated areas which are dominated by buy-to-let properties, namely city centre flat markets.
In these zones, there is a risk of much bigger house price falls. “If we see average price falls of 10pc, you can easily see a scenario where in some places prices could barely move downwards and in others they will fall double that,” adds Hudson.
Even without the headache from the buy-to-let sector, the toll of high rates will continue throughout the housing market for years.
The jump in mortgage costs struck an immediate hammer blow to buyer demand, which is now filtering into house price falls. Thursday’s rate increase will also immediately hit the 1.4 million homeowners on variable or tracker rate mortgages, which move in line with the Bank Rate.
But the biggest strain will be for the millions of homeowners who have so far felt no effect whatsoever.
Across 2023 and 2024, around 3.4 million homeowners will come to the end of fixed-rate deals, according to UK Finance. The numbers are particularly high because the stamp duty holiday helped to drive a huge jump in transactions during the pandemic.
In 2023 alone, half a million of these are coming to the end of two-year fixes, meaning they took out loans when it was possible to get deals at less than 1pc. For a borrower with a typical £200,000 loan, the difference between paying 1pc and 4pc is £6,000 a year.
High mortgage rates mean that a buyer purchasing an average property with a two-year fix and a 25pc deposit will need to use 28pc of their household disposable income to cover their mortgage costs. From 2010 to 2019, the average was 20pc, according to Pantheon Macroeconomics.
Lenders are gearing up to step in to support struggling homeowners. The Financial Conduct Authority, the City regulator, has issued guidance that lenders should allow struggling homeowners to extend their mortgage terms or make temporary switches to interest-only payment structures without the usual affordability checks.
“The worry is that whatever lenders’ best intentions are, there are always people who fall through the cracks,” says Hudson.
Between 2022 and 2024, UK Finance expects the number of homeowners in mortgage arrears will have jumped by 38pc to 110,300. This will be the highest level since 2014, when the market was still recovering from the financial crisis.
Homeowners face a double blow: those rising rates will hit them just as they are grappling with high inflation. “I think the two in combination are quite concerning. We are going to see people who are struggling this year,” says Hudson.