Taking the euro would ease mortgage pain

AN IMPORTANT part of the case for Britain joining European Monetary Union and bringing in the euro is that mortgage interest rates would be lower. Seven million hard-pressed households would get relief where the pain is greatest.

Mortgage rates now run up to 8 per cent or more on a total debt of pounds 435bn. A 2 per cent cut would be worth over pounds 8bn to borrowers, the equivalent of a 4p in the pound cut in income tax focused on the 28 per cent of households who have mortgages. A similar drop in rates on pounds 100bn of other personal lending would be worth pounds 2bn more. This would surely be a clincher in a referendum.

There is another side of the coin. The population has slightly more in deposits and bonds than in loans. A 2 per cent cut in interest paid out to them would cost pounds 10bn. So the effect of a cut in interest rates might be just to redistribute a large sum from savers, including many pensioners, to owner-occupiers.

Lower interest rates, essential for business investment, could cause a political upset among voters.

Yet it is unlikely that banks and building societies would be able to maintain their present margins if rates fell. In 1997, households paid out pounds 42bn in interest and got back pounds 26bn. They were charged an average rate of 8 per cent, and got 5 per cent - an average of anything from zero on current accounts rates to higher savings rates.

The financial institutions' margin of 3 per cent, or pounds 16bn, is high, and highly vulnerable to competition of the kind which will increase whether Britain is in the euro or out of it.

Banks clearly cannot reduce zero rates of interest any further, so deposit rates cannot be cut by as much as loan rates. The so-called "endowment effect" of free current account deposits on bank profits is reduced when interest rates fall.

There will also be more intense competition in the single EU banking market, leading to lower loan rates and higher deposit rates, including more widespread payment of interest on current accounts.

The effect might be to cut bank and building society margins by one percentage point in the household market, or about pounds 5bn. Average rates for depositors might fall by only 1 per cent, while rates for borrowers fell by 2 per cent. So savers might lose only pounds 5bn, while borrowers still gained pounds 10bn. This would be the equivalent of a net income tax cut of 2.5 pence in the pound, or a pay rise of about 1 per cent, for all households taken together.

If British inflation rates remain low, in or out of EMU, they will be similar to those in the euro countries, measured by the EU Harmonised Index of Consumer Prices, which sensibly excludes mortgage interest. So lower nominal interest rates would mean lower real interest rates. This would again benefit borrowers, but partly at the expense of savers.

However, if inflation remains low, house prices will not rise as rapidly as in the past, and the real burden of repaying a mortgage will increase over time, as inflation will not reduce it as much as in the past.

The advantage to mortgage borrowers is that their debt servicing payments will be less in real terms at the outset, and more in later life, when they have a better chance of higher incomes and lower family costs.

Lower mortgage rates will increase the demand for houses, and to some extent consumer demand in general. It will then be up to the Chancellor of the Exchequer to decide whether a looser monetary stance should be offset by a tighter fiscal policy.

An obvious first step would be to abolish mortgage interest relief. It has been reduced to 10 per cent this year, and is worth just under pounds 2bn to borrowers. It would be like reducing a 4p-in-the-pound income tax cut to 3p.

There might be a once-for-all surge in house prices, but after that they would slow down, because houses would no longer be seen as an inflation hedge. If the timing is right, a big cut in mortgage rates could be just what is needed to lift the economy out of the slowdown.

The wider economic effects of lower euro interest rates and lower mortgage rates on the UK economy would be entirely beneficial. The European Central Bank could not run interest rates up and down to deal with excess demand problems specific to the UK. It will have to fix interest rates to suit the EMU area as a whole, and changes would thus be smaller and less frequent than they have been in the UK in the last quarter century.

It is often assumed that British euro mortgage rates would move from variable to fixed inside EMU. The shift toward fixed rates in the UK so far does not have the significance many people claim. Fixed rates are often only for one to three years, after which they switch to variable. They are in effect an incentive to lure borrowers into a contract in which they bear the brunt of the risk for most of the period.

The continental countries show a mixed pattern of fixed and variable- rate mortgages.

If the ECB varies euro rates less than national central banks have done then borrowers will risk less by entering into variable-rate mortgages. Fixed rates are likely to become more common in the UK, and for longer periods. But they will have to be renegotiable at reasonable intervals if they are not themselves to carry the risk that a rate of, say, 5 per cent comes to look high in real terms if inflation falls to zero.

The UK has a relatively high proportion of owner occupation, a high loan- to-house-value ratio, and thus a high mortgage debt compared with most EU members. It also has the lowest cost of moving between owner-occupied properties, even if the time taken to move is higher.

If mortgage payments become lower and less variable, the drawbacks of the high debt-income ratio of about 75 per cent will become less because the interest-income ratio will fall sharply. The advantages to the UK economy of greater labour mobility, thanks to less volatile house prices as well as lower moving costs, will be considerable.

The continental countries have the advantage of lower mortgage rates than Britain, but they need to tackle the disadvantage of higher moving costs.

Christopher Johnson is former chief economic adviser to Lloyds Bank, and now UK adviser to the Association for the Monetary Union of Europe.