An individual or household buying a property usually becomes involved in a chain of transactions in which some are trading up and others moving down in terms of size and price.

For this process to work, there has to be someone on the bottom rung, usually the first time buyer (although more recently this role has been taken by the buy-to-let investor). As a result, many lending institutions have special low-cost mortgages for the first-time buyer, at a time when incomes are low and therefore the debt burden is high.

First-time buyers (FTBs) accounted regularly for 45%-55% of activity in the housing market between 1980 and 2000, but this part of the market has been very weak in recent years.

The number of FTB loans dropped from 150,000 in the first five months of 2006 to just 57,900 from January to May 2009, a decline of a third. The 2009 FTB share was 37%.

A greater sense of financial reality seems to have affected the FTB market. The size of the average advance has dropped (to £95,625 from the peak of £119,250 in mid-2007), which represents 75% of the purchase price. Until 2008, 90%+ was normal.

If the huge reduction in interest rates is factored in, the trends are even more striking. The interest repayments as a share of income were 14.9% in mid 2009 where 20% or more was normal two years earlier. From these figures the impact of lower house prices and interest rates is apparent but the difficulty of getting a mortgage is implied by the fact that FTBs need to have a larger deposit.

It is not house prices per se that are the key to the housing market. Rather it is the concept of ‘affordability’ that matters, the price of the house relative to the purchasers’ income and to the cost of servicing the mortgage (i.e. interest rates).

Whilst it is true that house prices are higher today than they were during the boom of the late 1980s, the fact the buyers’ incomes are higher and interest rates are less than half those of 1988 means that in ‘real’ terms, houses are still more affordable (that is cheaper) than they were throughout the 1980s and into the early 1990s, despite the recent surge in prices.

In 2003, interest payments accounted for just 11% of FTBs’ incomes, compared with a peak of 27.1% in 1990. The jump in interest rates, to 5.75% in mid-2007 pushed this measure back up to 20.7%, the highest for 15 years when the housing market was in a deep depression. More recently, however, the fall in Bank Rate to historically low levels has meant that for borrowers on tracker mortgages, especially, the proportion of income needed to service interest payments has dropped to around 15%.

The mix has changed. Back in 1992, it was higher interest rates and lower debt levels compared with today’s still historically low interest rates but record debt levels. But the effect could be just as serious for the homeowner.

Exposure to risk as interest rates climbed

The experience of the late 1980s exposed the risks some people took when they borrowed up to the limit of their earnings. In the spring of 1988, interest rates fell to 7.5% and house prices were soaring at annual rates of 20%+.

Anxious to get on the property ladder and take advantage of some tax benefits that were soon to end, buyers piled into the market. Lenders calculated the amount they were prepared to advance based on earnings and the monthly repayments with rates at this level.

When in the autumn of 1990, base rates had climbed to 15%, some homebuyers found that they could no longer maintain the mortgage repayments and prospective buyers were deterred by the high prices and repayments.

Cooling of the housing market

With interest rates in double figures for four years, there had to be some adjustment. House prices took the strain, and fell from the peak reached in 1988-89.

This necessary cooling of the market left some of those who had bought in the previous year or two with outstanding mortgages which were larger than the value of the property, a phenomenon known as negative equity.

Although there had been times in the past when house prices had failed to keep pace with inflation (and therefore fallen in real terms), this was the first time since 1945 that prices had fallen in nominal terms.

A dangerous cocktail

There are striking similarities between the late 1980s experience and recent events:

• house prices soared
• earnings increased and
• interest rates fell to historically low levels.

To this dangerous cocktail was added ‘liberal’ lending policies by a number of financial institutions which were prepared to give mortgages in excess of 100%, borrower and lender in effect gambling that house prices would continue to rise.

The process continued, and accelerated, until 2007 when inflation started to edge up, and with it interest rates were increased. This put a huge strain on the heavily indebted personal sector, a strain which was borne initially by the housing market and house prices.

Confidence evaporates

Once the market turned, and confidence evaporated, prices spiralled downwards. Even the fall in interest rates did little to help.

• Firstly, financial institutions tightened lending criteria and few first time timers had the necessary deposit. Even those that had, sat tight for fear that prices had further to fall.
• Secondly, as rates started to rise, and were expected to continue rising, fixed rate mortgages became increasingly popular. Those who locked into these fixed rate deals have missed out on the dramatic easing of Bank Rate and have not been able to trade off falling property prices with much lower mortgage repayments.

Strong rebound constrained

Looking ahead, three factors are likely to constrain a strong rebound in housing activity that might be expected following the marked improvement in affordability:

• the rise in unemployment will create uncertainty amongst potential buyers and dampen down demand:
• continuing problems in the financial sector will constrain the supply of mortgage finance: and
• the widespread incidence of negative equity amongst those who purchased properties from 2006 will act as a brake on turnover.

So while prices should firm and rise a little in 2010, and activity pick up, it is not likely to be a very strong recovery.

With the macroeconomic policy emphasis on maintaining a low inflation environment, the dynamics of the housing market are changing.

Burden of mortgage debt slows housing market

In previous generations, the burden of a mortgage which might have accounted for 25% of disposable income at the start was quickly reduced when inflation (price and wage) was running at double-digit rates.

Now, however, if 5% earnings growth is thought to be consistent with the inflation target, the burden of the mortgage debt will be harder to run off. This could slow down the number of transactions and put downwards pressure on house prices (as will the fact that the size of average advances, linked to earnings growth, will be growing only slowly).

The effect of lower interest rates

A key benefit of low inflation has been lower interest rates. (See Chapter 6: Effect of Stability and Low Inflation.) As interest rates dropped from double digits to 5% or less, it has meant that at every income level, people have been able to borrow more, and they have.

But more money has been injected into a market in which the number of houses has not increased to the same extent.

The result of the pressure of excess demand on inflexible supply (as in any market) is that prices rise.

Now that the interest rates have adjusted to lower inflation, this boost to house prices has run its course. Going forward, increases in house prices should be aligned more closely with earnings growth to keep affordability at current levels.

Greater stability

This greater stability of house prices, which is part of a more general economic stability, will mean home owners will no longer be able to rely on a surge in house prices to offer them a capital gain. Increasingly, houses will have to be viewed as somewhere to live rather than as some sort of investment which promises a quick financial return.