The recent sharp fall in mortgage rates and continued strong growth in wages has significantly reduced the scale of the UK’s housing affordability problem, according to a new report by Oxford Economics.

The firm adds that, consequently, the risk of a steep correction in house prices is much lower than it appeared a few months ago and it expects the recent steady pickup in housing market activity to continue.

Andrew Goodwin, chief UK economist at Oxford Economics, says: “Our Housing Affordability Index, which is based on the affordability of mortgage payments, suggests that house prices are currently 14% overvalued. This is down from 29% last summer.

“Though existing mortgagors needing to refinance this year still face a marked increase in debt servicing costs, the average uplift is now likely to be just under 200bps. Had mortgage rates stayed at their Q3 2023 levels, the average increase would have been 330bps.

“We now expect house prices to fall just 4% from peak-to-trough, a far smaller drop than in previous cycles. But such a shallow cycle would leave valuations still very stretched, limiting the scope for strong price growth in the recovery and keeping activity below historical norms.”

Recent inflation developments have affected both the growth and monetary policy outlooks, and the prognosis for the housing market now looks markedly better than it did in 2023. The sharp fall in mortgage rates since the middle of last year is the main reason. Swap rates have fallen as market sentiment has swung away from anticipating further tightening of monetary policy towards pricing in aggressive cuts in Bank Rate during 2024. In January to date, two-and five-year swap rates have been 162bps and 138bps lower than their July 2023 averages.

Lenders have passed on the bulk of the fall in their funding costs. In December, quoted interest rates on average two- and five-year fixed rate 75% loan-to-value mortgages were 119bps and 103bps below their July levels.

Goodwin adds: “Strong wage growth has also helped to reduce the scale of the unaffordability problem. As valuations have become less stretched, interest from buyers has picked up. Mortgage approvals troughed at just over 44,000 in September but recovered to 50,000 in November. However, this was still 20% down on the average monthly level of approvals in 2022, while net mortgage lending was in negative territory in six of the eight months to November. So, the market is still very subdued by normal standards.”

Mortgage rates look likely to stabilise and could even rise

Recent announcements from lenders suggest the January data for quoted mortgage rates is likely to show a further drop. However, swap rates have risen slightly since the end of last year, and Capital Economics thinks there is limited scope for further falls in mortgage rates in the near-term.

Goodwin comments: “Current market pricing is broadly consistent with our baseline forecast that the Bank of England will cut Bank Rate by 100bps this year. But we see the risks as being skewed towards rates falling more slowly, and if markets are disappointed by the pace of rate cuts then swap rates could rise further.

“Our baseline forecast assumes swap rates remain relatively flat this year then drift lower in 2025, consistent with our view that the neutral rate is probably a little lower than markets anticipate. Absent a further steep fall in house prices, these conditions would slow the affordability correction. So, while the recovery in mortgage activity should continue, stretched valuations mean we expect approvals in 2024-2025 to remain some way short of the levels seen in the years either side of the pandemic.”

Those refinancing will come under less pressure than feared

The picture has also improved for the 1.5m borrowers due to refinance their mortgages in 2024, according to the report, which stated that if mortgage rates had remained at the levels seen in Q3 2023, some borrowers would have been offered new deals at rates more than 400bps higher than their expiring ones. However, on average this year, Capital Economics expects borrowers will face a rise of around 330bps.

“Recent announcements from lenders suggest the January data for quoted mortgage rates is likely to show a further drop. However, swap rates have risen slightly since the end of last year. Our latest forecast is consistent with the average borrower seeing their interest rate increase by 195bps. This still represents a significant increase, particularly for those borrowers that have taken out a large loan relative to their income, and we still expect levels of mortgage arrears and repossessions to rise this year. But the numbers getting into financial stress should be much smaller than would have been the case had mortgage rates stayed higher. With unemployment still on track to peak at a relatively low level, the number of forced sales should remain well contained.”

Goodwin concludes: “The combination of a gradual improvement in demand and a limited number of forced sales mean that we expect house prices to drop by less than 2% this year. If we’re right, this would mean a peak-to-trough decline in house prices in this cycle of around 4% – the smallest fall of any cycle since 1845.”