How much do homeowners stand to lose on the UK housing market?

At the beginning of October last year, Richard asked “Is the UK housing market on the brink?” (read article here). Conclusion – little danger of collapse in the short term, but any dropping away of mortgage approvals would change this view. By the end of November, mortgage approvals had indeed started to fall sharply, and Richard said the UK housing market was “over the edge” (see article). Mortgage approvals continued collapsing, and in January we said that the mortgage approvals figures implied that the UK housing market would be falling 5% year-on-year by this summer. This is now looking a little on the conservative side – Nationwide figures show UK house prices have fallen five months on the trot, while data from HBOS said the UK housing market fell 2.5% in March, the biggest monthly drop since 1992.

So how far could UK house prices fall? The IMF said last autumn that UK house prices were 50% above where their models suggested house prices should be, although this month they toned it down to 30%. The honest answer is that nobody knows how far prices could fall, as there is a huge margin for error on long term economic predictions. We tend to stick to shorter term projections, and look at things like mortgage approvals. Mortgage approvals are a reliable predictor of UK house prices six or seven months ahead, and current data implies year-on-year falls of between 5% and 10% by early autumn (and this projection is likely to worsen, because the banks are becoming increasingly reluctant to lend, which means that mortgage approvals and hence house prices could fall much further).

If we were to have a longer term guesstimate, history suggests that when the UK housing market crashes, it tends to fall about 25%-30% from peak to trough in real terms. But given that UK house prices rose about 270% from 1995 to the end of 2007, there’s a risk that this current crash (and it is a crash) could be worse.

Let’s assume, then, that UK house prices fall by 30%. How much do homeowners stand to lose? A lot of homeowners will think that they’ll lose 30%, but they’re wrong. It’s actually a lot more. Buying a house is a leveraged investment, and the degree of leverage depends upon how big your mortgage is in relation to the value of the house. Consider someone who has a house worth £400k, and whose charitable parents have coughed up £200k for a deposit. If house prices fall by 30% (so their house falls to £280k in value), they’ve lost £120k. Unfortunately house price falls don’t make mortgages smaller, so if they sold their house, they’d only get £80k of their £200k deposit back. This means that they’ve lost 60% of their money.

Then consider someone who put up a deposit of £80k to buy this hypothetical £400k house (so that’s an 80% mortgage). A 30% fall in the value of their house leaves them in negative equity – their £80k deposit is wiped out, and they owe £40k. Maybe this person is one of the 20,000 people in the City who are forecast to lose their jobs. This wouldn’t have been a big problem in the 1990s, when the government generously agreed to pay the interest on anyone’s mortgage if they were made unemployed (no matter how big your mortgage). Now, you can only receive assistance on the first £100,000, and you’re not eligible to mortgage relief if your partner works more than 24 hours per week or if you have more than £16k of savings.

You can see from the examples above how a house price crash would have severe consequences for the economy. Due to the leveraged nature of home buying, a housing crash can greatly reduce the spending power of consumers. It’s no coincidence that house price crashes result in (or occur at the same time as) recessions. The only way out is for central banks to slash interest rates in order to encourage borrowing again, which will eventually revive the housing market.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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