Should we reform the mortgage market?

7.8 million homes have been purchased using a mortgage since the new regulations of the Mortgage Market Review (MMR) came into force 10 years ago. In total, there are currently 8.8 million outstanding mortgages, which equates to just under 30% of all households. As two thirds of all sales are reliant on mortgage finance, the ability to access this credit is crucial to enable individuals to buy homes. Its availability, or lack of, directly feeds through to the demand for housing and ultimately will impact the number of homes that are built.

Following the Global Financial Crisis (GFC), the MMR led to more stringent lending criteria being introduced. These were:

• Loan to Income (LTI) flow limit, which meant no more than 15% of a lender’s new mortgages could be at or above 4.5 times the applicant’s income
• Stress testing, which meant applicants had to prove they could afford mortgage payments in the scenario that the Standard Variable Rate (SVR) increased by 300bp

Stress testing was removed in August 2022, with regulators assessing that the LTI flow provided enough resilience.

Should affordability stress testing be reintroduced?

Over the past two years the economic environment has changed significantly, not least the 500bp increase in the base rate. But despite these events the housing market has remained broadly unaffected, which suggests the MMR regulations have proven to be successful. For example, the proportion of mortgages in arrears of at least three months peaked at 2.5% following the GFC. Currently only 0.95% are in arrears despite the recent rise in interest rates. Similarly, a peak of 0.11% of properties were repossessed in Q1 2009, but as at Q4 2023, just 0.01% were repossessed. This partly reflects the regulations that required households taking out mortgages post-2016 had to prove they could manage mortgage payments should rates increase by 300bp. So far households seem to have been resilient to rises in rates, which has meant fewer distressed sales. This has been a key factor in recent house price falls being far more muted than following the GFC.

Figure 1: Proportion of mortgages in arrears and properties taken into possession

Source: UK Finance

There is no question that the Bank of England stress test has been effective in the last two years of interest rate increases, by keeping repossessions and mortgage arrears far below the levels seen after the GFC. Still, interest rates have now likely reached their current peak, rigorous stress testing may not be a top priority. And of course, the LTI flow limit does continue to provide resilience on its own. Moreover, since its removal, banks have proven to be self-governing with the implementation of their own stress-testing as a form of risk management. Given these factors, we consider there is no immediate need to reintroduce the blanket regulation while the LTI flow limit remains. 

But have the regulations gone too far? 

In the 10 years leading up to the GFC, mortgage approvals averaged 1.25 million a year. In the decade following the implementation of the MMR, the average was nearly half that level at 780,000 per year. This reduction in activity is stark and has led to concerns the regulations are too restrictive and are excluding potential first-time buyers from the market. Still, prior to the GFC, the market saw very high but volatile house price growth. Average house price growth between 2001 and 2007 was 12.5% per annum, ranging between 3.2% and 25.3%. In contrast, house price growth in the subsequent period between 2009 – 2015 averaged 3.4%, with a low of -1.1% and a high of 8.3%. A sustained lower level and variance of house price growth would be more favourable for all buyers. 

Do we need to broaden the range of mortgage products?

At the start of 2024, there were 5,899 mortgage products on the market according to Moneyfacts. This is the largest number of available products since March 2008, when there was 6,192. On the face of it, this suggests that mortgage product availability is in good health in the UK. However, the question may not be do we need more mortgage products, but do we need different types of mortgage products? Particularly ones that might support first-time buyers. 

The lack of long-term fixed-rate mortgages in the UK has been discussed extensively and was subject to a Government review twenty years ago by David Miles. Gordon Brown was an advocate while in government, more recently, the Labour party has promised to introduce 25-year fixed-rate mortgages should they win the upcoming election. 

In the UK, most mortgages are fixed for up to two or five years (89% in 2023). Longer term fixed-rates are unpopular with borrowers due to high exit penalties and uncompetitive rates. But they are common in several European countries, and the US.

There is no doubt these longer fixed-term mortgages can protect borrowers from interest rate fluctuations. But can they also provide more stability at a macro level? In particular, do they insulate the housing market against large peaks and troughs in house price changes?

Figure 2 shows a selection of European countries where mortgages of fixed-terms longer than 10 years are common. The proportion of new mortgages fixed for more than 10 years ranged from 92% in Belgium, to 22% in the Netherlands as at Q3 2023. Over half of all new mortgages in each of these countries were fixed for more than five years. In the UK, it is very different, with only 0.2% of new mortgages fixed for more than five years. 

Figure 2: Proportion of mortgages by fixed-term and annual house price movement

Source: European Mortgage Federation, European Central Bank, Nationwide

The UK saw a larger fall in house prices in the year to Q3 2023 than the European countries where long-term fixed mortgages are more common, except for Germany. Of course, each individual market will have their own nuances and drivers of house prices, but there does appear to be a link between long-term fixed-rates and more stable house prices.

The US is quite unique, where 30-year terms are the most common mortgage product. Generally, these mortgages come with little or no prepayment penalty. So, as interest rates move down, homeowners can refinance and take advantage of lower rates. This feature is not one available outside of the US. However, unlike fixed mortgages in the UK, US mortgages are not portable. As a result, in periods of rising interest rates, the home mover market can be stagnant. That is the current position in the US, where mortgage holders who switched to low-rate mortgages in 2020-21, have little incentive now to move as this would mean a new mortgage product on a significantly higher interest rate. This means for-sale activity in the US is currently very muted. This can lead to a lack of availability of homes for potential first-time buyers and pushes prices up due to a lack of supply.

House prices in the US increased by 5.5% in the year to Q3 2023, according to the Federal Housing Finance Agency. In addition, it is worth noting that the US model is only feasible due to Ginnie Mae, Fannie Mae, and Freddie Mac. These three Government-sponsored agencies provide a federal supported securitisation process that enables lenders to absorb any interest rate risk. These nuances are important when considering the introduction of new products.

Like with any other mortgage product, pricing would be key to the take up of long-term fixed-rate mortgages. Providers of these mortgage products may not be able to provide rates as competitive as two or five-year fixed products. The fact that mortgage rates are expected to gradually decrease over the next few years may also deter consumers from locking in a long-term mortgages if refinancing comes at a significant cost.

We do consider long-term fixed mortgages beneficial for the stability of the market and would mitigate the need for stress testing. However, until the challenges of competitive prices and large exit penalties are addressed, demand will only be at the margins. This would come at a cost for lenders and therefore would likely need the financial support or backing of a government organisation.