How Saving Hurts House Prices

When house prices are rising strongly, we tend to save less. But something painful happens when we start to save more...

Last week, in House Prices, Burgers And Buffett, I explained why I think falling house prices will benefit not only first-time buyers, but also millions of homeowners who plan to reach for a higher rung on the housing ladder. As you'd expect, reactions to this article were sometimes hostile, especially from homeowners grown accustomed to prices rising year after year after year!

According to the Halifax House Price Index, the average house price is down 3.7% in the past twelve months. This is the first annual fall since 1996, and marks the end of a twelve-year housing boom. Alas, I have some bad news for anyone who hopes that the housing market will soon turn the corner and set off on another climb upwards...

House prices and the savings ratio

Generally speaking, borrowing and saving are opposite sides of the same coin. When pushed into borrowing heavily, we find it hard to save simultaneously. Likewise, when we're trying to save hard, we try to avoid borrowing at the same time. In other words, trends for borrowing and saving tend to head in different directions.

One way to study our willingness to save is to examine the savings ratio, which shows the proportion of our take-home pay which we save. Take a look at the following table, which records house prices and the savings ratio over the past 24 years:

Sources: Halifax House Price Index; UK Statistics Authority

When house prices rise, the savings ratio usually falls (and vice versa)

As you can see, when house prices are rising strongly, the savings ratio tends to fall to lower levels. Conversely, when the savings ratio rises to higher levels, house-price rises tend to be modest or negative.

This trend is particularly pronounced at extremes, that is, during housing booms and busts. During the Eighties housing boom, the savings ratio more than halved between 1984 (10.3%) and 1988 (4.9%). However, in the ensuing property crash, the savings ratio bounced back and was persistently high between 1991 and 1997.

Mathematicians would describe these two sets of data as being `negatively correlated'. In other words, they tend to move in opposite directions. Indeed, the `correlation coefficient' between house-price rises and the savings ratio is -0.6. A correlation coefficient can vary between +1 (moving perfectly in step) to -1 (being perfectly opposed).

Thus, a correlation coefficient of -0.6 suggests a somewhat negative relationship between these data. So, as one set of numbers tends to rise, the other falls roughly six in ten times (60%). By squaring the correlation coefficient, we can estimate the `cause and effect' between the two datasets. At 0.36, this figure indicates that house-price changes may account for over a third of movements in the savings ratio.

Having hit a 48-year low of 2.9% in 2007, the savings ratio has begun to creep up again. I suspect that this is because the `wealth effect' caused by strongly rising house prices is fading fast. Hence, in order to boost our financial security, we Brits are beginning to return to the ancient art of saving. It's about time, too!

Finally, if Britain rediscovers the joys of saving, then this could be particularly good news for first-time buyers. As mortgage lenders demand higher deposits in return for access to their best rates, first-time buyers are forced to sit tight and save harder. If house prices continue to decline during this period of retrenchment, then new buyers will benefit from bigger deposits and lower prices. Hurrah!

More: Find marvellous mortgages via the Fool | Shame On Northern Rock! | Why House Prices Must Fall