The greatest threat to mortgage holders

Mortgage holders should be apprehensive about the property market's unexploded bomb

Today I'm looking at what's seen as an unexploded bomb for the property market: interest rates.

A problem with using interest rates as a forecasting tool is that you have to make two forecasts. You firstly have to forecast when rates will change and by how much before you can attempt to forecast when and how much property prices will change. Compare this with other measures, such as the house prices to average earnings ratio, or current average rents, where you don't have this problem. (That's not at all to say those other measures don't have weaknesses.)

Bearing that in mind, let's take a look at the history of interest rates in relation to house prices over more than half a century.

The 1950s

For decades leading up to 1954 interest rates stayed very low. Then there was an increase in the bank rate from around 3% to 7% in three years.

These higher interest rates only lasted about six months, but house prices rose during this period and continued rising in the years afterwards, throughout the 60s, where rates didn't move much.

The 1970s

From the early 70s the base rate went from around 5% to 13% inside two years and stayed high at plus 9% for almost four years.

During this time the base rate was usually above 11% and peaked at over 14%. However, house prices continued to rise through the whole period and for years afterwards.

The 1980s

Next there was just a brief period of lower rates before they leaped back up to 10% in a year, and then up to 17% about one year after that. Rates stayed high, mostly over 9% and often much higher for a very long time indeed, but house prices continued to rise and rise and rise.

The 1990s

At the very end of the 1980s and for the start of the 90s, house prices started falling. Here's the interesting bit though: this wasn't until we'd had 11 years of constantly high interest rates throughout the 80s and part of the 70s.

Interest rates fell rapidly for most of the time property prices were falling, while the government tried to contain the market. Rates plummeted to around 5% in four years. Prices and interest rates then barely moved for years. After that, as interest rates rose, so did property prices.

The 2000s

Then, from the late 90s to mid-2007, interest rates fluctuated down and up quite gently, but always quite low, historically speaking. The lowest point was in 2003 at 3.5% and the highest 5.75% in 2007. After nearly a decade of these low interest rates and small moves, we had a property-price crash.

I'll summarise that information:

• Two out of four times when interest rates rose high and fast, house prices just kept climbing even for many years after rates had again cooled.
• One time when interest rates rose significantly house prices didn't fall until interest rates had been high for 11 long years, casting serious doubt on whether interest rates were the cause.
• When house prices recently fell it was only after a long period of low interest rates with just modest increases.

Taking the above, there is no evidence that house prices fall because rates are high, because they have recently been high, or because they have risen rapidly. This is not to say that modern matters, such as very low personal savings, record debt and more homeowners than ever, won't make increasing interest rates more likely to cause another price crash. That is also a possibility. It may also be that high interest rates could contribute in some circumstances, it's just they don't show up here.

Surprising conclusions

Before writing this piece I had a title in mind: The greatest threat to house prices. I expected to see a much greater correlation with rising interest rates tearing into house prices, and that would be a warning to us with interest rates at a low of 0.5% and seemingly poised to take off (sometime). In hindsight, if it was that obvious, forecasting house prices would be easy.

Hence, I've changed the title to The greatest threat to mortgage holders. This is because, whether or not the property market continues to churn out gains, homeowners with mortgages are likely going to have to find a lot of extra cash when interest rates rise again. If property prices don't fall, it's going to be even harder for new buyers to get on the market as well!

Inflation-adjusted house prices

The reason for the surprising results may be because I'm looking at the actual house prices. If we adjusted for the effect of inflation we may find that there is a stronger link between house prices and interest rates. However, it's the actual prices that are of concern to the vast majority of homeowners, because that's what can put them into negative equity.

Whilst we're talking about inflation, interest rates usually rise with inflation, but so do property prices. That would explain why house prices can apparently defy gravity whilst interest rates rise and even in the years afterwards when rates have again cooled. Property has a long record of being a good asset to combat inflation.

More: The future of house prices | The link between house prices and salaries