Interest rate rise will cause mortgage defaults
A new article in the Business Insider has warned that any UK interest rates rises will &lsquo;place a significant strain on homeowners&rsquo; monthly mortgage payments, after those who have not repaid the principal loan amount on an interest-only mortgage are expected to pay back substantial amounts of money by the end of the loan period. Low interest rates coupled with rising house prices increased the popularity of such mortgage schemes, and the Citizens Advice Bureau has warned that almost one million Britons will be affected when interest rates rise sometime in 2016.
A lone house is seen at the construction site of an urban transformation project. Reuters

We're making huge mistakes in Britain's property market that will come back to bite us all very soon.

On the face of it, rising house prices coupled with people being able to get a mortgage at low rates feels like a fantastic place to be. Especially after the pain of the 2008 market collapse.

But that's a myopic view, because any rise in interest rates will place a significant strain on homeowners' monthly mortgage payments.

On top of that, the Citizens Advice Bureau warned that in two years time, Britain will see a huge number of people unable to pay their mortgages — mainly because they took out interest-only mortgages. That means by the time the loan period comes to an end, they will not have paid off a single penny in capital.

They'll be forced to pay up or get out.

It's exactly like the US subprime crisis, all over again.

And because prices are so high, it takes longer to save for your first purchase. Britain is incubating a generation of renters to the point where it will become near impossible for a millennial to own a home without inheriting or getting their parents to give them the cash. House prices are rising too much and too fast for wages to keep up and the lack of housing supply is forcing people to basically rent for the rest of their lives.

In other words, we have not just one ticking timebomb on our hands, we are navigating a minefield.

Interest-only mortgages

British mortgagees have been happily scampering around like pigs in muck ever since interest rates fell to a record low of 0.5% in 2009.

Money was cheap and it still is. It allowed us to take a respite on some of our debt repayments, including mortgages, and gave us more cash in our pocket each month. The British economy even returned to growth.

Life looks pretty sweet.

Now, house prices are averaging £277,000 ($421,957) as of June 2015, according to the Office for National Statistics. That's a big increase, so it looks like we don't have to worry about negative equity.

This is because if people want to sell their homes, it's likely they'd make a profit from the sale:

ONS

But it isn't as simple as that.

The Citizens Advice Bureau, which gives consumers free, confidential, and impartial advice over issues such as debts, welfare, housing, and consumer rights, warned today that around a third of homeowners that took out an interest-only mortgage, prior to the clampdown on these housing products since 2012, have no idea on how they are going to pay back the banks when the mortgage repayment period comes to an end.

Interest-only mortgages mean that homeowners just pay back the interest on the debt from the bank over a certain period of time, which is usually between 25 to 30 years. It doesn't chip into the principal loan amount (i.e. the original price of the house). Therefore, at the end of the loan period, the property owner is still expected to pay back the full amount in a lump sum.

The Citizens Advice Bureau warned that 934,000 UK home owners have no plan for doing this. Britain could encounter the first round of these problem owners in 2017.

The only option, unless you happen to have hundreds of thousands of pounds knocking about, is to sell up or get your home repossessed.

Facebook/tinyhousegiantjourney

Selling up is obviously a more favourable option. However, considering the life of the mortgage is around 30 years, it will be the older generation that may find themselves stuck for somewhere to live.

This is because, even if they've made a profit from selling their home, it is less likely they'd be able to get a mortgage for a second home. They don't have much income and will probably die before they can pay off their debts.

It's also a gamble because you don't know where house prices will be by the end of your loan, if you're just planning to sell the property on.

One of the many case studies in Britain's mainstream press illustrate how this could be a huge problem for retirees or those on low incomes, who had been enjoying low mortgage payments for their whole lives.

In the Daily Mail, retired headmaster Gordon Parry, 68, revealed that when it came to the end of his interest-only mortgage term, the bank he borrowed from, as well as a raft of other high street lenders, refused to extend the term.

Although he eventually found a lender willing to extend his home loan on an interest-only basis until he turned 80, he's pretty much saying that he's hoping to die before he has to be forced to sell up and find a new property. It is very unlikely he'd be able to get a mortgage with no income and in his age bracket.

Meanwhile, the BBC had a story about the kind of people who got an interest-only mortgage in the first place.

One person, identified as Sarah from Brighton by the BBC, said she and her husband took out an interest-only mortgage to make it more affordable because they just had their first baby and were (and are) on low incomes. However, they are apparently already struggling to make those payments each month and have already fallen into arrears.

Interest rate rises

BAML

Gordon Parry's and Sarah's stories are troubling because they shows the wide range of Britons who are holding a timebomb in their hands.

In Sarah's case, she blamed the banks for giving her the interest-only product in the first place.

"We were silly. We'd just had our first baby," she said to the BBC. "But they shouldn't have given the loan. We didn't understand what we were taking on and didn't think about having to pay it back."

Apparently she has 16 years until their mortgage term is up but she says it's a "constant worry." And she should be worried. Her family could find itself homeless.

This sounds dramatic, but it's possible.

Firstly, as with Gordon Parry, she'll face the same situation: she'll have to pay up in full or have her house repossessed. But in Sarah's case, there's a greater and more imminent danger at hand — interest rate rises.

We all know that global central banks are looking to raise rates soon. In Britain, it is tipped for some time in 2016, although the exact date cannot be predicted. We've had rafts of economists warning that keeping record low rates will hurt the economy in the longer term.

Britain cannot keep record low rates forever. They will rise eventually.

Worryingly, surveys and data over the last year are all in line with showing that millions of Britons would struggle if rates moved up, even fractionally. And this isn't just for interest-only mortgage holders.

In June this year, Ocean Finance revealed that 7 million property owners would struggle with their mortgage payments if interest rates eked up by just 1%. Out of those surveyed, 13% said they'd outright not be able to cut costs sufficiently and would immediately fall into financial trouble.

A 1% hike is only equivalent, when looking at standard variable rate mortgages, of paying an additional £55 a month for every £100,000 owed.

In November, ICM Research showed that a third of mortgage borrowers would struggle to meet repayments if interest rates rose by 2%.

A month later, the Money Advice Service warned that more than half of homeowners are not prepared for interest rate rises. Even more worryingly, 19% said they would really struggle to cover any rise in interest rates in their monthly repayments and 47% of people would find it hard to cover an increase of up to £150 extra a month.

Nation of renters

A woman and her son are seen in their 60-square-foot sub-divided flat, with a monthly rent of HK$3,800 ($487), in Hong Kong February 2, 2015. Reuters

The fact that sentiment hasn't really changed over how much one can afford on mortgage repayments is really testament to the weak wage growth for the average Briton.

Many people hoped that getting on the property ladder was the solution to low wage growth. That's not to be sniffed at because at least you're protected from landlords and their exorbitant rental increases.

However, if you're unable to own the home and are forced to sell up, you've got to rent — again.

Bob Pannell, an economist for the Council of Mortgage Lenders, gave a stark warning about how "dysfunctional" the housing market is at the moment.

A notable nugget from his blog highlights how lack of earning power is somewhat at the core of the conundrum of not being able to own a home but will struggle to pay rent because competition for housing is so fierce:

Demand for rental property increases because property prices continue to outstrip earnings, and would-be first-time buyers have no housing equity growth to draw upon (unless it is held by their parents). So, although young people continue to aspire to be home-owners in the long run, the rising house price-to-earnings ratio often reinforces current lifestyle preferences for renting.

Property prices look set to remain stretched relative to incomes because of the long-term imbalance between supply and demand. Over the last 15 years or so, the widening gap between house prices and earnings has been exacerbated by low inflation and interest rates.

And here's the key chart:

Council of Mortgage Lenders

Meanwhile, if you're forced into renting, it doesn't mean you'll save much money. Apart from the irritating fact that you're paying off someone else's mortgage, soaring rent is becoming such a problem that people are calling for rent control, like that of the US.

Average central London rent is £2,583 ($4,000) a month. If people are struggling to pay interest-only mortgage payments, which would be significantly less than that, then suddenly re-entering the rental market is not exactly a tenable situation.

So, Britons are stuck. It's not a matter of if we're going to be plunged into a housing crisis — it's when.