Will loan-to-income caps reign in London?

House prices in the capital are pushing forwards, but many areas of the country are still in recovery mode.

Richard Sexton
7th July 2014
london map pin uk

The challenge is to fine-tune policy to prevent the London market becoming a world unto its own, whilst still supporting the country’s outskirts. We may need to put a break on house prices in the capital, but the regions still need more revving.

Institutions far and wide are throwing in their tuppence worth on how to handle the capital. Suggestions to dampen demand in London range from introducing loan-to-income caps, raising the base rate, reigning in Help to Buy and increasing capital requirements. But which is the right one?

Loan-to-income caps

In an attempt to control London, Governor Carney and the FPC have introduced new regulation.

The Bank of England has stepped in on loan-to-income (LTI) ratios, capping the total volume of high LTI lending. Banks must now cap the number of loans they are issuing, worth more than 4.5 times a borrower’s income to 15% of new mortgages.

The Old Lady of Threadneedle Street is also beefing up stress-testing. Lenders must stress test potential borrowers against a 3% interest rate rise – a slight toughening of current rules.

Carney’s decisions to exercise his ‘extended macro-prudential toolkit’ came slightly out of the blue. He was initially reluctant to take on the powers, most likely aware that real change in the housing market must come as a result of increased house building – a job for the government rather than the Bank of England.

So why show his macro-prudential muscle now?

Increase pressure from abroad has played a part. The International Monetary Fund (IMF) has been urging the UK to clamp down on lending to borrowers with high LTI ratios.

The move also followed – and closely echoed – voluntary regulation brought in by several lenders. Both Lloyds and RBS banks self-imposed limits on high LTI lending, capping homes loans worth more than £500,000 to four times a borrower’s income.

These moderating measures are a response to concerns that a high proportion of lending in the capital is at high loan-to-income ratios – a proportion which has grown as house prices in London have sped away from the rest of the UK. Currently, the proportion of lending in London at loan-to-income ratios of over 4.5 is about 19%, compared to 9% nationally. Thus, loan-to-income caps should have a greater effect at slowing demand at the bottom of the market in the London.

Prices in the capital increased 13.3% year-on-year in April, according to the latest House Price Index from LSL Property Services. In the rest of England and Wales (omitting London), annual price rises were a mere 6.3%. High loan-to-income lending in London is more risky to lenders – the market has risen quickly, but if prices were to fall, they would be likely to fall further.

That’s some of the logic behind Carney’s decision.

But in fact, there are already signs emerging that pressure in the London market is starting to dissipate – even before loan-to-income caps were introduced.

LSL’s House Price Index reveals a cooling at the very top of the London market. Twelve London boroughs saw prices fall in April. The exclusive Prime Central boroughs of Kensington and Chelsea and the City of Westminster saw the largest monthly drop in house prices – down 2.7% and 2.9% respectively.  

The London market may have begun to cool even without Carney’s intervention.

Help to Buy

Loan-to-income caps were not the only idea floated to tackle London.

The European Commission took a rather different tack. Rather than a focus on income ratios, they warned Osborne to rein in Help to Buy – which they argued is fuelling the hot property market in London.

But claims that the scheme is driving property demand in London are wide of the mark. The capital is plagued by high demand and low stock, but Help to Buy is not the cause. The two-tier growth of the country has highlighted London as a destination for aspiring workers – a Mecca for jobs. That is driving a booming population, which is predicted to grow in size to over 10 million in the next fifteen years.

Dwarfing the minimal effects of Help to Buy in the capital are factors including the expanding Buy-to-Let portfolios of landlords, and foreign investors taking advantage of safe haven London as a bank for their investment. Recent research from Morgan Stanley found Buy-to-let investors in the capital are having ten times the impact of first-time buyers getting on the ladder through the Help to Buy scheme.

In fact, Help to Buy can only be held accountable for 0.6% of mortgage-funded house-purchases in the capital – a figure which would appear even lower, were the large number of cash-only purchases in the capital factored in. And the average purchase price of houses bought through Help to Buy 2 is just £134,950 – hardly the top end of the market.

Still, the Treasury have said they will ban borrowers applying for Help to Buy funding borrowing more than 4.5 times their income – ensuring that the scheme is brought somewhat in line with the FPC income cap initiative.

More needed on house-building

The Mortgage Market Review regulations introduced at the end of April have already introduced increased affordability testing for potential borrowers.

Other options to even out the property market include raising the base rate, or further ramping up capital requirements.

The Office for Budget Responsibility have forecast that a 2.5 percentage point rise in mortgage rates would increase repayments on a typical £150,000 mortgage by £230 a month – which would reduce lending demand by pricing out borrowers with lower incomes.

Another option is to increase capital requirements for high LTV loans – thereby making high LTV loans more expensive. (Lenders would pass on the costs of higher capital requirements by way of higher rates). But this goes directly against the agenda of Help to Buy, which is to support borrowers struggling to save for a deposit.

All the opposing views are muddying the waters of economic policy. But they all have one thing in common – they are treatments rather than cures. Prices will continue to rise as long as demand outstrips supply – and the British appetite for property is insatiable.

The Governor is wading in on loan-to-income caps. But Osborne needs to meet him in the middle by doing more to stimulate house-building.

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