You have probably heard a lot in the press recently about the risk of a credit crunch. But what is it and how does it affect you?.
We look at five ways a credit crunch could affect your financial well being in this article
What is a credit crunch?
Lets look first at what a credit crunch is. Basically it means that credit becomes difficult to obtain throughout the financial system.
Lending money is a risky business so banks have to continually assess risk before they lend money – this is why your credit report is so important, as it gives a risk assessment of your finances.
With a huge number of people defaulting on their mortgages in the USA, banks are reluctant to lend money to certain sectors and hence make credit more difficult to obtain.
As the risks of lending to these sub prime customers is shared throughout the banking system, banks become reluctant to lend to each other, so there is less money available for other sectors of the economy, such as businesses.
This reluctance to lend, triggered by an alarming rise in loan and mortgage defaults is what is termed a credit crunch. So lets look at how this bad situation in the USA can affect you in the United Kingdom.
1) Sub prime mortgages and loans may become more difficult to obtain
As the credit problems are arising from high levels of loan defaults in the US sub prime sector, there is a risk that lenders will become more reluctant to lend to sub prime applicants over here.
Those with credit impairment or very poor credit histories might find it either more difficult, or more expensive, to borrow money in the near future.
This could lead to more people seeking debt management, or other forms of debt relief.
2) House prices might go down
As house prices rise, people need to borrow more money to pay for them. If banks and building societies tighten up their lending policies to reduce risk, they might reduce the salary multiples for mortgage amounts.
Making it more difficult to borrow large amounts for house purchases means one thing – houses become less affordable and therefore fall in price.
3) Your pension may be affected
As pensions invest massively in the stock market, the value of your pension is linked closely to the performance of the stock market.
Fears of a credit crunch have wiped billions off the value of shares recently and this is reducing the value of your pension. If stock markets continue to fall in a bear market, your pension will suffer as a result.
4) Unemployment in the UK might rise
If banks reduce their lending to business customers, those businesses will be unable to invest in new premises, equipment and products. As their expansion plans will be affected, they may be unwilling to take on new staff, or even have to shed some employees.
Reduced investment by businesses will lead to higher levels of unemployment, so you might lose your job or have less promotion opportunities, if a credit crunch continues for some time.
5) Fears of a recession increase
Combining these factors we see all the signs of an economic downturn, or recession, looming. This is not good news for anybody as it will reduce everybody's prosperity for the next few years.
An economic downturn might have one benefit though, as reduced consumer spending will reduce inflation and therefore limit future rises in interest rates. The Bank of England may even start to reduce rates which will help ease recessionary pressures.
We've painted a bit of a gloomy picture in this article, however it shows how increasing numbers of mortgage defaulters in trailer parks in Florida can affect consumers in the United Kingdom.