When rates finally rise, things are set to get nasty

A good recession followed by a bad recovery. Trite lines like this are often wide of the mark, but this one bears some truth. The fallout of the economic downturn over the last few years – though harsh – was less gruesome than first feared in terms of overall unemployment, bankruptcies and repossessions. The risk is that far more misery than might have been expected lies ahead.

Everyone knows that sooner or later (and it will probably be later) interest rates will have to go up, and when they do it’s going to hurt a lot of people who are already sore from the effort of keeping up with a rising cost of living. After stagnant wages, reduced working hours, cuts to tax-credits, higher inflation and escalating energy prices – the next chapter of Britain’s living standards squeeze is set to be climbing interest rates.

The immediate threat of a rate rise has receded due to pitiful growth figures over the last two quarters which leading forecasters say are set to continue (in case you were distracted by other news, the NIESR have predicted growth of 0.1% in the second quarter of 2011), and, thankfully, a slight dip in inflation. But make no mistake – unless the economy goes into freefall – in 2012 we can expect to see steadily climbing interest rates.

We don’t have a clear sense yet of what the impact will be. One reason for this, rather surprisingly, is that we don’t really know exactly how many people are already struggling in some way with their mortgage. There are, of course, statistics about levels of home repossessions – and they have remained very low. In part this is because this recession, far more than previous ones, has been characterised by people avoiding the horror of losing their home by striking some sort of agreement (known as ‘forbearance’) with their bank, which allows them to reschedule their repayments, often by shifting from a ‘repayment’ to an ‘interest only’ mortgage for a period. Forbearance has been helpful to many people. But it buys time; it doesn’t solving the underlying problem.

What is becoming clear is that the number of households covered by forbearance is very large – and this is now starting to spook our economic authorities. The FSA highlighted this earlier in the spring, and the Bank of England has just chosen to do so in its recent Financial Stability Report.

The first line of support to households who get pushed over the edge is often those who provide debt advice. So it is telling that the Consumer Credit Counselling Service, a charity that helps those in financial distress, has issued a starknew report on financial fragility in Britain. It estimates that over 750,000 mortgages are in some form of forbearance, and when this is added to the number of mortgages in arrears, the authors get a grand total of 1.2 million mortgages under pressure – that’s more than one in ten of all outstanding mortgages. If correct, this is scary. It points to a potentially far bigger problem for households in the years ahead then you would think simply by looking at the Council of Mortgage Lenders projections for repossessions.

This warning shot from CCCS also helps to focus attention on a little appreciated but wider problem: the rising burden of debt repayment for low-to-middle income families, which has grown over recent years, reaching the levels of the early 1990s when interest rates were dramatically higher (see the chart). How can that be right, you might ask, given interest rates have been on the floor for some time?

Source: Growth without gain?, Resolution Foundation, May 2011

Part of the answer is the larger mortgages that people took out over the last decade due to rising house prices, and the easy availability of 100% mortgages (for instance almost one in three first time buyers on a low-to-middle income in the years running up to the financial crisis used one). It also reflects the fact that lower interest rates often didn’t get passed on to borrowers – particularly lower income ones. And let’s not forget that household incomes have actually been falling recently, making it harder to service debts. So perhaps we shouldn’t be too shocked by alarming Shelter researchwhich finds that over two million people used credit cards to pay their mortgage or rent in 2010 – an increase of almost 50% in a year.

Given this backdrop, if the cost of debt repayment shoots up alongside higher interest rates, at the same time as living standards continue to be squeezed – as is expected throughout 2012, with inflation continuing to outpace wages, and government cuts to tax-credits and benefits ratcheting up – then we can expect the consequences to be dire. Debt advice charities are already starting to think about the need to scale up their operation to meet higher demand. Indeed, it is the severity of the this risk to households budgets (and to the banks that have lent to them) that will be one of the key factors restraining the Bank of England who will otherwise be itching to return interest rates to a more normal level as soon as is feasible.

At the moment all this is under the radar. Issues like forbearance struggle to make it onto the money pages of the papers. That’s sure to change. Nothing turns a dry economic story into a turbo-charged political one quite like fear of losing the family home. This could get nasty.

This blog first appeared in the New Statesman.