Rising interest rates are considered to be detrimental to the housing market. Interest rates affect how much buyers will pay for homes, so the higher the interest rates, the worse off the overall housing market is. Interest rates hit home buyers in many different ways. Here is an explanation of how recent interest rates hikes could hit the UK housing market.
Interest rates had been at historic lows for extended periods of time in the wake of the Great Recession that hurt the entire world’s asset markets. Central banks had ensured that rates would remain low for some time in order to stimulate the markets by making borrowing relatively easier. As the world economy has picked up, central banks all over the world are hiking rates to nip the prospect of inflation in the bud. In the UK, the Bank of England has instituted several rate hikes. Thus far, the rate hikes have been muted out of Brexit-related uncertainty, but there is the chance for future increases to keep pace with the rest of the world as Brexit becomes a thing of the past.
When interest rates rise, borrowers must pay more for their loans as the financing costs have escalated. Mortgage lending rates usually track UK Gilts, and higher rates mean that mortgages are more expensive. It follows that something has to give when the cost of borrowing increases. What it usually means is that buyers can afford less house since more of their payment would be going towards interest rates. Their budgets do not get bigger to match the higher costs of borrowing. Thus, a buyer who would be in the market for a larger property may have to settle for a smaller one so they could afford it. All of this adds up to depress prices since sellers may have to cut the price of a home to attract buyers or make their homes more able to fit within budgets.
At the same time, many in the UK have taken advantage of historically low rates and taken out variable rate mortgages. For these mortgages, payments readjust periodically to reflect the prevailing interest rates. When rates go higher, the amount of payment increases. Where this comes into play is with new borrowers seeking variable rate loans. First, they may be more hesitant to take out a variable rate loan knowing the costs will be going up in a rising rate environment. When buyers have a more traditional loan, there payments are higher. Variable rate loans allow buyers to stretch their dollar further. Second, the rise in interest rates may keep those who may want to sell their home to upgrade to a bigger home from doing so with a variable rate mortgage.
Rising rates also have the effect of putting a damper on credit in the economy. One would think that banks would want to lend more money if the rates are higher. However, banks actually want to lend more money when rates are lower because they can get a higher spread between the cost of their own capital and the mortgage interest rate that they can charge their customers. In addition, rising interest rates are often thought to be the precursor of a general decline in economic conditions. In advance of that, banks may tighten the reins on extending credit, knowing that tougher times may be ahead. Thus, borrowers who may receive credit when interest rates are lower may be less likely to obtain a mortgage when interest rates are higher because banks grow more concerned about credit risk. Rising rates also hurt bank profits, and in that environment, the bank will be worried about protecting its balance sheet as opposed to making more loans to increase profits. Banks must take certain steps to protect themselves when they know that tougher times are ahead. Thus, rising rates may have the potential to put a damper on what has been a red-hot UK housing market.