High interest rates and falling House Prices will fundamentally alter both the housing market, and also the economy. The last two house price crashes co-incided with two deep recessions and if prices fall as much as expected, it will worsen an already weak economy.

But, it is not all bad news, falling prices could be a lifeline for potential future buyers and in the long-term help to rebalance the market and even encourage an economy less focused on passive wealth gains.

The change in conditions is causing a big readjustment. In the past low interest rate environment, assets like bonds and house prices soared. But, as interest rates rise the price of government bonds falls. The Resolution Foundation show that the UK has experienced its biggest fall in wealth for decades, and this trend will continue if interest rates remain elevated.

In recent decades, the ratio of wealth to income has soared and this has benefitted a relatively small share of the population who own substantial wealth. When house prices are rising, homeowners can withdraw equity through remortgaging to spend on holidays, and home extensions. But, with high-interest rates and house prices falling, equity withdrawal is going into reverse as people seek to overpay their mortgage – I’m trying to do that at the moment.

But in the short-term, this will depress consumer spending.

Falling house prices cause a big dent in our perceived financial well-being – more so in the UK than anywhere else in the world. In the UK over 50% of wealth is tied up in non-produced assets like land and housing. This compares to 35% in Japan and 26% in Germany (FT). The high price of housing and land has distorted the economy, meaning we spend more on land and property and less on productive capital. The hope is a fall in property and land prices could in the long term free up business to invest in more productive capital.

On the other hand, although wealth is falling, there is a compensation of higher interest returns. For example, those with savings will see a rise in interest income. So far, there has been a greater rise in interest income, than a rise in debt payments, this will soften the blow. Though the debt burden will increases as more people remortgage to higher rates. Also the benefit of higher interest income is mostly felt by the wealthier deciles. Those on low and mid incomes are more affected, by higher borrowing and renting costs.

In addition to negative wealth effects, higher mortgage payments are reducing disposable household income, causing a further squeeze on spending. Amongst workers under 40, this is particularly acute. This is another factor that will contribute to recessionary pressures in the UK in 2024. Some argue the UK economy has been more resilient than expected, in 2022, the Bank of England forecast a long-lasting recession, which has not yet materialised. But, this is somewhat misleading. The economy usually grows at 2.5% a year, but GDP has still not recovered its 2020 peak. Even another year of stagnating growth would be very damaging.

By the end of June 2023, only 56% of mortgage holders have actually been affected by the recent rise in interest rates. In 2024, increasing numbers of households will face the interest shock, which will further hit both the economy and the housing market. The problem is that as households struggle with higher interest rate costs, they will also face negative equity, a deeply problematic combination. Now it is true many households who bought in the 2010s have built up good equity levels. Equity in housing is in better shape than in the 1990s and 2000s, but it doesn’t alter the fact recent buyers risk negative equity at the same time as crippling mortgage payments.

Another problem with falling house prices is that it will adversely affect housing construction (House building to slump – at FT). Already there are signs that the slowdown in the housing market is causing construction to be put on hold, with new builds falling and private house builders holding back as they struggle to sell in a quiet market. Despite frequent government promises to build more houses, the change to make council targets advisory rather than compulsory is the most significant factor, which will reduce long-term supply. The problem is that inflation and a shortage of skilled labour has pushed up housing build costs and combined with weak first time buyer, there is less incentive to build. This is worrying for the long-term. Although the role of supply is sometimes exaggerated, in the long-term, the UK does need to build more to help deal with a shortage – especially in the rented sector. A housing crash and fall in building would affect long-term affordability and supply

Benefits of falling house prices

Falling house prices is not all bad news. It is really good for potential homebuyers. One forecast is for the ratio of house price to income ratio to fall from 8.9 to 5.1, possibly even 4. Through a combination of nominal house, price falls and rising nominal wages (currently running at 7%). This would be a game-changer for many potential homebuyers. If house prices were to fall 25% it would reduce prices from £287,000 to £215,000. In the short term, buyers will still struggle because of high mortgage costs and the difficulty of saving for a deposit. But, the fall in prices would represent a seismic shift in affordability and help to return the housing market to a fairer one.

How would a housing crash affect Renters?

How would a housing crash affect renters? It is a mixed bag. At the moment, the turmoil in the housing market is making it worse for renters. Firstly, some landlords are selling, reducing the amount of properties on the market. Secondly, the prospect of house price falls and high interest rates is discouraging potential buyers. It is estimated around 12% of renting demand is from potential homebuyers who are waiting for prices to fall. The result is an unfortunate storm of rising demand and falling supply, pushing up prices, even as disposable income is not keeping up. In the longer term, a fall in prices would enable more renters to start buying, reducing pressure in the rented sector.

You might expect falling house prices to lead to lower rents, it did to some extent in the 1990s and 2009, but there is no guarantee.

If interest rates remain elevated, then landlords may require a relatively higher yield from property. During the long-boom in house prices and low interest rates, yields on renting fell, which is what you would expect. But, if interest rates rise, the opposite may happen. This may not be what renters want to hear. But, it is not all bad news, the renting yield will be improved by falling prices. There is some anecdotal evidence large investors are looking to buy up property as prices fall.

Interest rates and inflation.

High inflation and high interest rates are causing house prices to fall. But, how would a crash affect rates and inflation? The bad news is that inflation is proving more stubborn than predicted. The headline rate is falling.

But, underlying core inflation is still close to 7%, well above the 2% target. The problem is that after years of real wage cuts, workers will be striving to catch up from the recent real cuts. With nominal wage growth at 6-7% and very poor productivity growth, it will be difficult to reduce service sector inflation without a very deep slowdown. This is why markets are expecting interest rates to remain elevated for a considerable time. However, future interest rate predictions are notoriously difficult. No one predicted 13 years of zero interest rates (2009-22) Few predicted the very sharp rise in interest rates in 2022/23. But, if falling prices and high interest rates do push the UK into recession, deflationary pressures could once again see interest rates fall.

The interesting thing about the analysis of the resolution foundation is that if interest rates stay at current level, house prices will fall 25% in nominal terms. But, if interest rates were to fall back to pre-covid levels of 0%, it would cause house price to earning ratio to rise above 10. That would mean more house price rises in the long-term. With high inflation, for the foreseeable future interest rates will remain high, but this could change in the next 24 months.

Banking sector

How vulnerable is the banking sector to house price falls? Banks are better capitalised than in 2008 when some needed government bailouts. The recent boom in house prices was not due to risky mortgages like in the early 2000s, but the very low interest rates. Correspondingly, a smaller share of households are at risk of default than in the past. Banks are relatively well-capitalised and making very high profit.

So far banks have profited from rising interest rates with lending rates rising faster than borrowing rates.

However, some financial institutions have been caught out by the unexpected rise in interest rates for example Credit Suisse and Silicon Valley Bank in US. The Bank of England have warned about the risky nature of “Liability Driven Investment” funds, which many UK pension schemes invest in and were facing meltdown during last September mini-budget. Falling prices and a rise in repossessions, could still alter the state of the banking sector.

Further reading

• Solutions for UK Housing Market
• Will the Housing Market become less overvalued?