A Handful Of Housing Horrors!

When things get tough in the housing market, homeowners should worry about these five shocks.

In his annual Mansion House speech on Wednesday night, the governor of the Bank of England warned that the UK faces a few tough years ahead.

Mervyn King said that Britain is facing its `most difficult economic challenge for two decades', thanks to falling growth and the steeply rising cost of living. In some cases, household finances will be stretched to the limit, thanks to modest pay rises being gobbled up by soaring food and energy bills.

Furthermore, as the housing market begins to slide, things look particularly shaky for homeowners. Mr King admitted that the era of cheap mortgages is over, so homeowners should be prepared for higher mortgage interest rates. Thus, what should homeowners watch out for as the housing market and the UK economy enter choppy waters?

1.    Laughable help for mortgage-payers

During the last housing crash, Income Support For Mortgage Interest (ISMI) kept the wolf from the door for hundreds of thousands of homeowners. ISMI is a state benefit paid to homeowners who are unable to keep up their mortgage repayments, often due to illness or unemployment. However, the cost of providing this support to homeowners became a burden, exceeding £1 billion in 1994/95.

Hence, as I warned in Big Holes In The Housing Safety-Net , the government slashed this benefit in October 1995. These days, out-of-work homeowners have to wait nine months (39 weeks) before receiving any government help with their mortgage repayments. What's more, support is limited to paying only interest on the first £100,000 borrowed, leaving most homeowners facing a shortfall. So, if unemployment starts to rise, mortgage arrears will quickly follow suit.

2.    Negative equity

Negative equity arises when a mortgage is larger than the value of a property on which it is secured. For example, a property worth £180,000 with a £200,000 home loan has negative equity of £20,000. Of course, if a property is worth less than the loans secured on it, then selling up will not clear the outstanding debts.

In other words, negative equity leaves you stuck in a property until you can reduce this overhang (or hand in your keys, only to be pursued later down the line). According to investment bank Lehman Brothers, if house prices were to fall by a quarter from the peak, around two million households would be in negative equity. With 11.8 million outstanding mortgages, a price plunge on this scale would give one in six homeowners a headache.

3.    Repossessions

In the early Nineties, mortgage arrears and repossessions kept me very busy in a professional capacity. As more and more homeowners found themselves unable to keep up their monthly repayments, I found myself working overtime most evenings and weekends in order to keep up with a backlog of insurance claims.

Alas, as I warned in Your Home Is At Risk, the number of homes being seized by lenders is rising steeply. Mortgage repossessions peaked at 75,540 in 1991, before falling almost every year to a low of just 6,030 in 2004. However, over the past four years, repossessions have bounced back and are expected to exceed 45,000 this year. In other words, 110,000 people can expect to be turfed out of their homes in 2008. For these unfortunate few, owning a home has proved disastrous.

4.    Higher mortgage rates

The governor of the Bank of England has stated that the Bank will take `whatever action is needed' in order to return inflation to the government's target. At present, the Bank or raises or lowers its base rate in order to keep the Consumer Prices Index (CPI) measure of inflation to within 1% either side of the CPI target of 3%.

Unfortunately, thanks to steep rises in the cost of food, fuel and commodities, CPI inflation hit 3.3% last month, its highest level since 1992. This breach of the 3% upper limit forced the governor to write a letter of explanation to the Chancellor, Alistair Darling. What's more, it seems likely that inflation will exceed 4% fairly soon, which effectively rules out any further cuts to the base rate in 2008.

In addition, the ongoing credit crunch (the reluctance of banks to lend to individuals and each other) has pushed up mortgage interest rates. Indeed, Fool partner Moneyfacts this week warned that the cost of two-year fixed-rate mortgages is now at a ten-year high. Ouch!

5.    Falling disposable incomes

Finally, household incomes are being hit by a triple whammy of rising inflation, higher taxes and lower pay rises. These combine to put the squeeze on household budgets, pushing down disposable incomes.

According to the Institute for Fiscal Studies, the average disposable income rose by 0.3% in 2006 and a further 0.9% in 2007 in `real' terms (after accounting for inflation). However, given the rising cost of food, fuel, gas and electricity, together with low pat rises, average take-home pay is likely to stagnate or fall this year.

So, in summary, after enjoying a NICE (non-inflationary, constantly expanding) decade, we should now brace ourselves for tougher times to come. Who knows, as borrowing falls out of favour, perhaps the ancient art of saving is poised to make a comeback? I certainly hope so!

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