Why inflation is so important to your mortgage repayments.
Regardless of whether you are a land lubber, or have been sailing the high seas, one thing you will not have been able to avoid over the last 18 months is inflation. It has been all over the news and has affected everyone in the UK to a certain extent. However, inflation is not new. In fact, it is necessary in a thriving economy. So, we will look at what inflation is in general and why it is important when it comes to mortgages.
Today we will cover:
What is inflation in simple terms?
Firstly, inflation measures how much more expensive a set of goods and services has become over a certain period. Usually a year.
It is a broad measure, such as the overall increase in the cost of general living in a country. Inflation can also be calculated against any individual goods or services. Specific examples include the cost of food, energy, housing, or the price of an automatic car wash. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.
CPI (Consumer Price Index)
Calculating the overall rate of inflation across every individual good or service would be a mammoth task. The UK government instead created something known as a shopping basket. Imagine this basket contains a few hundred of the most purchased goods or services. Financial institutions call this basket and its costs the CPI (consumer price index).
As the prices of the assorted items change over time so does the total cost of the basket. Movements in consumer price indices represent this change.
Within each calendar year the basket contents are fixed. Changes in the indices from month to month reflect only changes in prices, and not variations in the quality and quantity of items purchased.
However, the basket contents and associated prices are updated annually. This is important to reflect new trends becoming popular and older obsolete goods or services no longer having a large uptake across the UK.
For example:
- In 2023 e-bikes were added to reflect the popularity of this form of transport. Rail fares were updated to match increased ticket prices. Frozen fruit too.
- Likewise, CD albums were removed from the basket along with compact digital cameras. There is very little demand for these at present. Although I hope CD’s make a comeback in the future.
Regularly updating the basket contents also helps ensure that the indices reflect longer-term trends in consumer spending.
Why has it been in the news?
Initially, in the UK, the inflation target is 2%. Meaning that each year the price of those goods and services in the basket increase in cost by around 2% when averaged out. Low levels of inflation are needed to maintain a positive flow of liquidity (money) within a financial system. This gives consumers confidence to make a purchase using their money. This helps top sustain businesses and keep the system ticking over.
However, due to a large number of contributing factors including, the war in Ukraine, a disastrous mini-budget, Brexit and Covid-19, inflation has ramped up too much higher levels within the last 18 months. In October 2022 the rate sat at 11.1% mainly due to sky high electricity and gas prices.
Next as a result, everyone in the UK became embroiled in a cost of living crisis. Widespread goods and services became increasingly more expensive leading to many of the population having to choose between heating or eating. Almost everything in the CPI basket increased in cost rapidly.
Interest rates.
To avoid a runaway rate of inflation from crippling the economy, the Bank of England (BOE) increased their base interest rate from 0.10% in November 2021 to 5.25% in August 2023. This heralded good news for savers who would begin to finally earn some interest on their savings. Alas, it also meant that the cost of borrowing also began to rapidly increase from its previously low level.
Lastly, wages have increased to try and combat this increase to the cost of living. However, wages are no longer improving at the same pace as inflation. High wages actually help to fuel higher inflation as part of a cycle.
Cost of mortgage and housing inflation.
Due to interest rates rising in general, banks were having to pay more to borrow money from other financial institutions. The only way for them to balance the books was of course to begin increasing the rate of interest they were charging to their mortgage customers. Those customers on a BOE tracker mortgage felt the increased in mortgage cost immediately. Those on a fixed deal had a little more breathing space.
Mortgage borrowers had experienced prolonged periods of low interest rates following the 2008 financial crisis. Therefore, those coming to the end of a low-cost fixed rate experienced a sharp jump in monthly repayments when selecting a new remortgage deal. Even though inflation has dropped back to around 4.0% mortgage rates remain high. The BOE base rate still sits at 5.25% and monthly repayments still increase by hundreds of pounds per month compared to previous deals.
Also, those in rented accommodation saw their monthly rental jump upwards as landlords passed on the increases in their buy-to-let mortgages. However, some landlords have tried to keep their rents affordable instead of chasing pure profit and this has to be commended.
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What else does inflation affect?
Although the rising rate of inflation indirectly affected mortgage interest rates, it also affected how much mortgage providers were prepared to lend.
A mortgage company assesses your income and outgoings to determine your maximum possible mortgage amount. If the price of food, childcare, fuel, energy and financial commitments etc have all increased this will diminish your disposable income and limit your borrowing potential. Therefore, we have witnessed lenders restrict the maximum mortgages available across the board.
As potential borrowers are not able to borrow as much as they require to purchase a property, and the cost of that borrowing is higher due to the increases in interest rates, we have seen a drop in activity within the property market. First time buyers are at their lowest levels for a decade and many homeowners have held off from potential moves until the market settles down and the cost of borrowing drops. This in turn caused 2023 to witness a drop in the average house price.
What has the government done to help?
Firstly, the mortgage charter has been set up to help borrowers who are struggling to maintain repayments on their mortgage. This encourages mortgage lenders to offer short term solutions to the borrow. These options include taking a repayment holiday, switching to interest only, or by extending the term of the mortgage. If you feel you are struggling to keep up repayments on your mortgage you should contact your lender as early as possible.
Secondly, wage increases are slowing which will help ease inflationary pressure within the economy. Too much disposable income can help drive prices even higher as it encourages demand.
Finally, they have also provided cost of living payments to help those most vulnerable meet their essential needs.
The current outlook.
Inflation currently sits at a rate of 4%. It is still above target. The UK has also dipped into a shallow recession but is expected to recover quickly.
Experts expect the Bank of England to reduce the base rate of interest in 2024. This should give mortgage lenders the confidence to cut the cost of their deals. Lowering the cost of borrowing for millions of homeowners should help stimulate activity in the property market and ease pressure on household finances. However, the core rate of inflation does need to drop further before the BOE will feel confident enough to take action.
Food prices are stabilising, and energy prices have recovered with a lower price cap overall. Although some of the economic causes of high inflation remain, time has helped us adjust to their impact and limit the consequences.
In conclusion, the outlook is more positive but may take a few years to fully take effect.
How has inflation affected your mortgage? Share your experiences of price rises in the UK using the comment form below.
Post compiled by Grant Carpenter CeMAP, CeFA – 15 years of regulated mortgage advice.
Please note that the content listed within this post is purely for information purposes only and does not constitute advice.
