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The Actuary The magazine of the Institute & Faculty of Actuaries

Mind the savings gap

Personal debt in the UK is estimated to be about £1 trillion, including mortgage loans of £825bn, credit card debt of £55bn, and unsecured loans of £122bn. Over £6bn is paid in interest on that debt every month. That’s over £72bn each year spent on making interest payments.

Do the maths
A simple calculation implies that on average people are paying interest of about 7% per annum. But this is too simplistic. Mortgage interest rates are just under 7% at the moment. Borrowing on credit cards costs far more, unless people pay off their accounts at the end of each month or take advantage of special ‘interest-free’ deals. Those that borrow because they need to, rather than just for convenience, are probably paying much higher average rates of interest.
Extending our simple arithmetic, every one percentage point increase in interest rates means that, each month, nearly an extra £1bn must be transferred from people’s household spending and saving to service their borrowing. If personal debt were spread evenly over all adults, every adult would be paying £1,500 per annum to service his or her borrowing, in addition to the return of capital. Four times this year to date of writing, the Bank of England has increased interest rates by one-quarter of a percentage point. Each one-quarter per cent increment adds £50 per annum to the average amount payable to service people’s borrowing.

Poverty in retirement?
At the same time there is estimated to be an annual ‘savings gap’ of £27bn which is about one-third of the money we spend to service our borrowing each year. The savings gap is measured against a ‘gold standard’ of everyone saving enough to receive an income in retirement of two-thirds of final salary. Whether or not this is a plausible figure, the extent of any undersaving relative to retirement expectations is likely to be increasing. This is because the value of both occupational and state retirement provision is reducing and people are living longer.

Sensitivity to interest rate changes
How vulnerable are household incomes, measured over a lifetime, to increases in interest rates?
Median income is about £22,500 per annum, and so debt interest payments represent about 7% of pay on average. But many adults have no debt, or have paid off the majority of their mortgages, so the way that debt is distributed across the adult population is likely to be very skew.
A housing charity, Shelter, recently published a report showing that for first-time buyers the percentage of income needed to meet mortgage payments is reaching the level it was in 1990, just before the housing crash. At the peak of the housing boom the average cost of meeting mortgage interest payments was 20.5% of pay. By the end of 2004, mortgage interest payments are projected to be 17.8% of pay. However, this time it’s not because of interest rates rising unexpectedly. Instead, with interest rates still quite low, the problem is down to the level of lending. Building societies are lending up to five or six times annual salary on the grounds that low interest rates make repayments affordable. But people that borrow so much are acutely vulnerable to even small increases in interest rates.
The Family Fortunes model was developed for the actuarial profession’s Social Policy Board to illustrate how households can manage debt and savings to achieve maximum utility from their incomes over their lifetime. By adjusting the cost of borrowing and the cost of housing in the model, it’s easy to see the effect that changes in interest rates have on household wealth. For example, single people who have borrowed only two times their annual salary to buy a house need only adjust their standard of living, measured over their lifetime, by less than 1% for each 1% increase in the cost of net borrowing. At four times salary the adjustment becomes 5%, and at six times salary the adjustment is 10%.
The model is very simple. It assumes that mortgage lenders will take a very forgiving view to extending the term of borrowing at will and that the borrower will adjust his or her other saving and borrowing in an optimal way. Even so, the effect is that someone on average income will struggle to pay off their debt and be unable to save sufficiently to keep themselves off means-tested benefits in retirement. Crucially for the government, even if interest rates do not increase, a person on median earnings who has borrowed six times annual pay is likely to have to rely solely on the state for retirement income. Someone who has borrowed only two times annual pay, and who chooses to save the money that would otherwise have gone towards their mortgage, will be able to afford to save toward retirement and have some wealth left for contingencies (although such people are still likely to be eligible for means-tested benefits see figures 1 and 2).

A vicious cycle
In the real world, building societies are less sympathetic. If interest rates rise it is likely that some people will experience extreme financial hardship, at least in the short term, and that in some cases houses will be repossessed. Charities that counsel people in financial hardship are already seeing clients in serious financial difficulties as a result of increased borrowing costs. Many of these are people who took out discounted-rate mortgages. They overestimated the level of borrowing they could afford, making the step up to the lender’s much higher standard variable rate of interest hard to manage.
This can create a vicious cycle. Credit ratings plummet once borrowers miss payments on their mortgage, personal loans, or credit cards. New lenders then charge a high interest rate to compensate for the higher deemed risk, which often means that borrowers cannot afford their debt repayments and they need to continue to use their credit cards, increasing their borrowing at even more expensive rates.

Rising interest rates may undermine the security of those that hope to rely on housing as an investment. The higher the net cost of borrowing, the less able housing is to act as an investment itself, since growth in the value of the house (unless higher than would be expected on average) might not compensate for the increased cost of repaying the mortgage.
People are increasingly starting their working life in debt because of the cost of going to university and because of the increasing pressure to follow higher standards of living. At the same time, there is more pressure for people to make individual provision for retirement. It is not surprising that people have difficulty adjusting to these new financial expectations. With housing costs reaching record highs again, it seems that something is going to have to give. o