The Bank of England has moved to put limits on the mortgage market to prevent it becoming a risk to the UK economic recoveryReuters

Bank of England policymakers stepped in to shackle the UK mortgage market over fears that the rising level of household indebtedness poses a significant risk to the incipient economic recovery.

The BoE's Financial Policy Committee (FPC) is imposing a cap on the amount of high loans-to-income (LTI) mortgage lenders can dish out and tightening further the affordability tests for borrowers.

At its June meetings, the FPC noted a sustained increase in the number of high LTIs being issued; rising household indebtedness and the international evidence that suggests such an increase often precedes a financial crisis; and the increased likelihood that households with larger mortgage debt will fall into arrears.

"Taking this evidence together, the Committee assessed that there was the potential for a large adverse impact on aggregate demand from household indebtedness, with this risk more marked in relation to borrowers with higher levels of indebtedness," said the FPC.

"The Committee judged that the size of that impact on aggregate demand was sufficient to warrant intervening now in the mortgage market, given current conditions and the potential upside risks to the FPC's central view of the possible future path of the share of mortgages extended at high LTI multiples and hence to overall indebtedness."

Rapidly rising house prices, which the Office for National Statistics (ONS) said hit an average of £260,000 in the UK after rising 9.9% in the year to April 2014, mean borrowers must take on bigger mortgages to buy property.

Abnormally low interest rates thanks to the Bank of England's all-time-low 0.5% base rate mean borrowers can afford the repayments on larger debt.

But when the BoE raises rates as the economy recovers, monthly debt repayments will rise too. Those who have stretched themselves financially will have to cut back spending in order to service their mortgage debt – and some may even default.

This threat of mortgage defaults and tightened household consumption after interest rates rise is a risk to the UK economic recovery, which the BoE forecasts to see 3% GDP growth in 2014.

So the FPC voted to put an electric fence around mortgage lending from October 2014. Only 15% of a bank's net new mortgage lending is allowed to be loans whose value are 4.5 times or more the applicant's income.

"Most lenders were currently lending within this limit, and were expected to continue to do so, based on developments in the housing market implied by the Monetary Policy Committee's central view," said the FPC minutes.

"As such, this action was designed specifically as insurance against the risk that there could be greater momentum in the housing market than currently anticipated and that, as a result, lenders would face growing demand for loans at very high LTIs."

The FPC said it did not expect its moves to affect the pace of house price growth, which it believes will soon fall down to a rate similar to earnings growth. It added its remit is not to increase housing supply or limit house price growth, but to mitigate risks to financial stability in the UK.

"The Committee judged that it was acting early, in a graduated and proportionate way, to reduce the risk that more severe action would be needed at some point in the future," said the FPC.

Moreover, the FPC is forcing lenders to assess a mortgage applicant's ability to make repayments if the base rate were to be 3% above where it is at the time the application is made.

This is on top of the Financial Conduct Authority's (FCA) stricter affordability tests for lenders, to curb riskier practices, following its Mortgage Market Review (MMR).

Despite a falling number of residential mortgage approvals, which slumped to an eleven month low in May, the FPC said it thought underlying demand in the housing market was still on the rise.

Lower mortgage approvals "most probably reflected a shortage in residential properties coming onto the market, and delays associated with operational requirements from the introduction of the Mortgage Market Review (MMR), rather than a weakening in demand."