How interest rates affect house prices

Interest rates are currently at one of their lowest levels for 40 years, and this has been one of the key drivers behind the current strength of the housing market. Even though house prices have risen rapidly, homes remain affordable because interest rates have stayed low.

As a result, people have taken on large levels of mortgage debt. With this comes the danger that if interest rates rise significantly some home owners will find it difficult to keep up with mortgage payments. Even a small percentage point raise in the base rate - say from 4% to 5% - would represent a 25% increase in their burden of debt.

Adam Law, UK economist with Barclays Capital says: "The strength and direction of the housing market depends not just on where interest rates are going but what happens to earnings and to confidence. Low interest rates have, however, played an important part in the cycle because they have enabled people to get a foot on the mortgage ladder."

The other key drivers for rising house prices include:

1 Shortage of supply: tough planning laws mean that there are relatively few new homes being built, although this is likely to change in the south-east

2 A rising number of households: although the birth rate is falling, more people are living alone, getting divorced or living separately from their family. This increases the number of households and puts more pressure on the limited number of homes available

3 Property hotspots: good schools, new transports links and redevelopment all bring new buyers to an area

4 Fears about the stock market: people are concerned about recent stock market falls and see bricks and mortar as a much safer home for their money.

5 Unemployment - the number of people without a job has been falling but this could start to level out

6 Wages growth - so long as salaries continue to rise, people will be able to afford current levels of mortgage debt.

Mr Law believes that wage growth has an important part to play in the behaviour of the housing market. If inflation were to outpace wage growth over the next couple of years, this could have a negative effect on house prices.

For example, average income growth in the 1980s was 7.5% a year, while in the last few years it has been between 4% and 5 %. With the level of inflation at 2%, the real rate of earnings growth is between 2% and 3%.