The key chart
The key message
Rising financial inequality means that lower-income HHs have less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them. But what does this mean for debt vulnerability in the UK, given that lower-income HHs also hold a relatively small share of outstanding mortgages and consumer credit?
In its latest “Financial Stability Review” (5 July 2022), the Bank of England introduced a new measure of HH debt affordability that takes account of these factors to deliver an improved assessment of HH vulnerability to rising prices and higher interest rates. The key points are:
- The share of HHs with high, adjusted debt service ratios (DSRs) i.e. those who are typically more likely to struggle with repayments, is currently in-line with historic averages and well below pre-GFC peaks
- The BoE believes that this share is unlikely to rise substantially in 2022. Further fiscal measures will cushion serviceability this year and the shift towards fixed mortgages (80% outstanding stock) delays the pass through effect of higher rates
- Looking forward, the BoE expects this share to increase above its historic average in 2023, but to remain “significantly below the peaks seen ahead of the GFC.”
[In response to questions, Sir Jon Cunliffe, the Deputy Governor for Financial Stability, indicated that rates would have to rise significantly (200-500bp) above current market expectations for the bank rate (3.0%) for the share to reach previous highs.]
The obvious risks to this positive assessment, acknowledged by the BOE, include weaker growth, higher unemployment, persistent inflation, higher rates etc.
In the context of the recent deterioration in the net lending position of the HH sector, the risk that HHs may increasing their borrowing in order to fund rising living costs also remains important.
Financial inequality and debt vulnerability
What is the impact of financial inequality on household (HH) debt vulnerability?
Financial inequality means that lower-income HHs have less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them.
The share of income spent on essentials and taxes varies considerably across the UK income distribution (see chart above). HHs in the lowest income decile, for example, spend 94% of their gross income on taxes and essentials. In contrast, HHs in the highest income decile spend only 47% of their gross income on taxes and essentials. This means that lower-income HHs have much less freedom to change their behaviour in response to rising inflation.
The savings ratio of lower-income HHs is also much lower than the savings ratio of higher-income HHs (see chart above). HHs in the bottom three income deciles save less than 6% of their gross income. This contrasts with HHs in the top two income deciles who save more than 30% of their gross income.
Obviously, this means that lower-income HHs are much less likely to have a savings cushion than can protect against rising prices. ( Note also that the COVID-19 pandemic led to a further widening of the savings disparity in the UK, as noted in previous posts.)
That said, lower income HHs are also likely to hold a smaller share of both outstanding mortgages and consumer credit (see chart above).
The bottom three income deciles account for 1.6%, 1.2% and 2.3% of total outstanding mortgages respectively, a cumulative market share of just over 5% (see chart above). The top income decile accounts for 33% of total mortgages alone and the top three income deciles together account for more than two-thirds of total mortgages.
The breakdown of consumer credit follows a similar, if less extreme, pattern. The bottom three income deciles account for 1.5%, 3.0% and 4.0% respectively, a cumulative market share of just over 8% (see chart below). The top income decile accounts for 20% of total consumer credit alone and the top three income deciles accounts for more than half of total consumer credit.
In its latest “Financial Stability Review”, the Bank of England introduces a new measure of HH debt affordability that takes account of these factors to deliver an improved assessment of the HH vulnerability to rising prices and higher interest rates.
The BoE claims that, “the share of HHs with high cost of living adjusted DSRs on either their mortgage or consumer credit has remained significantly below the pre-GFC peaks over the past few years.”
In the case of mortgages, the BoE estimates that 1.7% of HHs had a high, adjusted DSR at the end of 1Q22, up from 1.4% in 1Q20. This is close to the historic average but below the pre-GFC peak of 2.8% (see chart above). The BoE is expecting this share to remain at around the current level for the rest of 2022. This assumes that government support measures will relieve the pressure of rising living costs and also reflects the fact that 80% of outstanding mortgages are fixed rate now versus 55% five years ago.
The story for consumer credit is much the same. The share of high, adjusted DSRs for consumer credit was 6.4% in 1Q22, up from 5.5% in 1Q20. This is also well below the pre-GFC peak of 9.5%. Again, the BOE is not expecting a major change here during the rest of 2022.
Looking slightly further ahead, the BoE believes that the shares of HHs with a high, adjusted DSR for both mortgages and consumer credit will increase in 2023, but “would remain significantly below the peaks seen ahead of the GFC.”
In response to questions, Sir Jon Cunliffe, the Deputy Governor for Financial Stability, indicated that rates would have to rise significantly (200-500bp) above current market expectations for the bank rate (3.0%) for the share to reach previous highs.
The obvious risks to this positive assessment, acknowledged by the BOE, include weaker growth, higher unemployment, persistent inflation, higher rates etc. In the context of the recent deterioration in the net lending position of the HH sector, the risk that HHs may increasing their borrowing in order to fund rising living costs also remains important.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.