First-time buyers hit by rising living costs

Fionnuala Earley, RBS Group UK Consumer Economist, said: "Our new index provides the most accurate picture available today of the squeeze on first-time buyers, by including the effects of tax, National Insurance, earnings and rising living costs, in addition to house prices and interest rates.

"Our first results show that higher living costs are making it more challenging for first-time buyers to enter the market, despite the lowest mortgage payments in almost a decade.

"But the news is not all bad – inflation is now beginning to fall and assuming earnings still rise and interest rates remain low, this should help to improve the ability for first-time buyers to enter the market."

The first release shows:

* The RBS FTB Ability to Buy Index has deteriorated for three consecutive quarters. At 98.6 in Q3 2011 compared with an average of 96.5 in 2009, the index also shows it’s harder to buy now than in the 2009 recession. This contrasts with house price to earnings measures which suggest conditions have improved;
* The rising cost of essentials during 2011 has outweighed the effect of falling house prices and rising incomes on the ability to buy;
* Ability to buy has deteriorated most in the East of England, East Midlands and London since 2009. The biggest improvements were in Northern Ireland and the North East.

But the results also contain some encouraging news. Low interest rates mean that even with the squeeze on household income, the debt-servicing burden has fallen to 2003 levels.

* In Q3 2011 a first-time buyer repayment mortgage took up just 52% of discretionary income (income after tax, National Insurance and spending on essential goods and services). At the peak of the market in 2007 this proportion was 84% and in 1990 it was as high as 123%;
* But rising living costs have prevented this improving further. Compared with the 2009 recession, the debt servicing burden, after taking tax and living costs into account, improved by 5.8%. Measures based on gross income suggest it improved by 8.7%

Low interest rates and squeezed discretionary income also mean that it will take a long time to save for a deposit, but not as long as in 2007.

* Assuming that house prices stay still, earnings grow at a modest annual rate of 2.5% and FTB can save 30% of discretionary income, it would take three years to save a 10% deposit;
* In London it would take 11 months longer, but in the in the North East it would take just 29 months to save a 10% deposit.

Earley said: "Traditional affordability measures only look at gross earnings, but the RBS Ability to Buy Index gives a more realistic approach by taking into account other essential calls on buyers’ incomes.

"It is particularly timely given the FSA’s emphasis on the assessment of borrowers’ outgoings in its latest proposals on mortgage regulation. But it’s also important at a time when inflation is putting such pressure on household budgets.

"It is a little surprising that even though house prices are falling and incomes have increased, FTBs are squeezed more now than they were during the 2009 recession. The rising cost of essential goods and services has eroded their discretionary income. But low interest rates are still a tremendous help.

"A 90% loan for a first-time buyer would take up just 52% of available income today compared with 84% at the market peak. This gives borrowers a much bigger financial cushion. But lower discretionary income and low interest rates mean saving for a deposit is still a hurdle."

House price to income ratios have improved, but the ability to buy is worse than 2009.

First-time buyer house prices were 18% below their 2007 peak in Q3 2011. Over the same period, gross earnings increased by 10%. The house price to earnings ratio (HPE) fell from 6.7 to 5 as a result, suggesting a big improvement in affordability. But in fact this hasn’t happened. The rising cost of living has squeezed households’ discretionary income and made their ability to buy to deteriorate.

The RBS FTB Ability to Buy index has increased for three consecutive quarters. (A rise in the index signals deterioration in the ability to buy.) In Q3 2011 the index reached 98.6, up 2% from the 2009 average of 96.5 when the economy was in recession. In the year to Q3 2011, FTB house prices have fallen by 0.5% and after tax incomes have increased by 3.3%. But, spending on food, transport and utilities increased by 7%.

The rising cost of essentials has outweighed the effect of falling house prices and rising incomes on the ability to buy. And this is even without taking account of other spending on clothing or even rent.

Ability to buy has deteriorated most since 2009 in the East of England, East Midlands and London. In Northern Ireland and the North East it has improved. But this doesn’t mean that these areas will see their housing markets recover rapidly. There are other factors, particularly the labour market, which have an effect. For example Northern Ireland saw the largest improvement in ability to buy in Q3 2011, but this region also has the UK’s highest rate of labour market inactivity and an economy very dependent on the public sector.

High inflation is the cause of the recent deterioration in ability to buy, but before the housing market peak, low inflation was an important factor in its improvement. In the decade to 2007 lower living costs meant FTB discretionary income rose from 50% of gross income to 55%. This, along with lower interest rates, made it easier for households to afford to take on and service debt and was a contributing factor to rising house prices up to 2007. But since 2009, general inflation has been increasing and the price of essential goods and services has been increasing more quickly. This has eroded FTB discretionary income to 53% gross income.

The actual cost of living is crucial when FTB make calculations about what they can afford, especially in an uncertain economic environment. The squeeze on their discretionary income is likely to be another factor hindering demand. The FSA’s approach to affordability set out in the Mortgage Market Review is also putting more emphasis on borrowers’ discretionary, rather than gross, incomes.

Inflation is now beginning to fall and will do so faster when last year’s VAT rise falls out of the calculations. This will help to improve the ability to buy, assuming earnings still rise. But, if the cost of food transport and utilities continue to rise quickly, buyers will continue to feel the squeeze for longer, even if house prices continue to fall.

Continuing low mortgage rates mean that the ability to service mortgage debt has improved to 2003 levels. At current house prices and assuming a loan to value ratio of 90%, mortgage payments took up about 52% of discretionary income in Q3 2011. This compares to 84% at the peak of the market in 2007. The impact of lower interest rates on mortgage affordability is brought home when comparing affordability now with the last major housing market cycle. In Q1 1990, when the bank rate was at almost 15%, a 90% loan took up over 123% of discretionary income.

But again, rising living costs have prevented this improving further. Compared with the 2009 recession, the debt servicing burden after taking tax and living costs into account, improved by 5.8%. Traditional measures based on gross income suggest it improved by 8.7% suggesting conditions are better than they actually are.

The picture differs across the UK too. In London FTB mortgage payment still takes up 69% of discretionary income, but in the regions in the North of England the proportion is close to 40%

Ability to buy for first-time buyers isn’t just about how much money they have spare to pay the mortgage. It is also about how long it takes to save a deposit. House prices change, as do earnings growth and the amount of interest earned on savings.  Each of these affects how long it will take FTBs to save the required amount.

Assuming that house prices stay still, that earnings grow at a modest 2.5% and that interest paid on savings is about 2%, it would take the average UK FTB three years to save a 10% deposit. And this is assuming they were paying no rent. FTB in London and the South East, unsurprisingly, would have to save for the longest at just under four years. FTB in the North, Scotland and Yorkshire and Humberside would be able to save their deposit the fastest. It would take these first-time buyers around two and a half years to save a 10% deposit.

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