Thousands of homeowners were plunged into negative equity this month as house prices slumped by £5,000.

The cost of an average home fell by 2.5 per cent during May, the biggest monthly decline since records began in 1991, figures from the Nationwide Building Society show. House prices have fallen by nearly £12,500 since the market turned in October.

This month’s slide in prices prompted economists to forecast that house prices would fall by more than 20 per cent in two years. This would plunge two million homeowners, or one in six mortgage borrowers, into negative equity, according to Morgan Stanley, the investment bank.

Howard Archer, of Global Insight, an economics consultancy, said: “The 2.5 per cent plunge in house prices is a real shock and will fuel concern that we are now headed for a sharp correction in house prices. Our latest forecast is for prices to fall by 7 per cent in 2008 and 9 per cent in 2009. However, it now looks more likely than not that house prices will fall by 10 per cent this year and 12 per cent in 2009.”

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Capital Economics, another consultancy, says that its prediction of a 20 per cent fall in house prices is “firmly on track”. Nearly 370,000 borrowers will be in negative equity if prices fall by a total of 5 per cent this year and next, Morgan Stanley said. Prices have already slipped by 4.7 per cent since the beginning of the year.

Many borrowers who bought a home late last year with a deposit of 5 per cent or less are now likely to owe more on their mortgage than their home would fetch on the market. Borrowers who run into difficulties and cannot meet their repayments then face selling their home at a loss.

The average value of a home is now £173,583, down from £178,555 last month and £181,584 in May last year. This month’s fall in house prices was the seventh monthly fall in a row – the longest consecutive period since the housing market crash in 1992.

Analysts have blamed the sudden downturn in house prices on the ongoing mortgage drought, as it has effectively banished all but the most well-established buyers from the market.

New buyers who do not have a deposit of at least 5 per cent can no longer secure a home loan unless they have a guarantor, while the most competitive deals are reserved for borrowers who have a downpayment of 25 per cent or more. Mr Archer said: “Unemployment is now starting to rise, which along with many homeowners having to remortgage at higher rates, is increasing the likelihood that a significant number of people will have to sell their house for ‘distressed’ reasons.”

The Council of Mortgage Lenders has forecast that repossessions will rise by 50 per cent this year to 45,000.

Thousands more borrowers face the prospect of being turned down for mortgages or having to pay higher interest rates because of the double whammy of sudden house price falls and stricter lending rules.

Brokers say that around one in four borrowers have had a “down valuation” in recent weeks, a situation in which a surveyor values a property at a lower price than the borrower expected before a new deal is agreed.

David Hollingworth, of London & Country mortgage brokers, said: “The less equity a homeowner has, the more mortgage lenders will charge for a new home loan deal.”

Homeowners coming to the end of fixed-rate mortgage deals are already being faced with soaring mortgage costs thanks to higher rates. The average cost of a two-year fixed-rate deal for borrowers with a 5 per cent deposit has risen from 5 per cent two years ago, to nearly 7 per cent today, figures from the Bank of England show. About 1.5 million homeowners are due to remortgage their homes this year.

Mortgage approvals for house purchases have slumped to record lows in recent months, suggesting that the dearth of buyers in the market will continue.

It can take up to three months to complete a house purchase after a mortgage is approved.

Louise Cuming, head of mortgages at Moneysupermarket.com, the price comparison website, said: “The Nationwide figures will fuel the ‘wait and see’ approach among the millions of homeowners too afraid to make a move in the current environment, which will add to further stagnation.”

Estate agents report that sellers are being forced to cut their prices sharply to entice buyers in the stalling market. Ed Mead, of Douglas and Gordon, the estate agent, said: “Many properties came on the market in January at last year’s prices, and when they didn’t sell, the prices were reduced by 10 to 15 per cent almost in unison.

“But now, anyone who wants an easy life and a sale must reduce prices another 10 per cent from what they think is a reasonable price. That adds up to a fall of 25 per cent.”

There are growing signs that the slump in the housing market is taking its toll on consumer confidence and spending. High street sales fell for the second consecutive month in May, according to a CBI report published yesterday, while consumer confidence slumped to an 18-year low.

Fionnuala Earley, chief economist at Nationwide, which forecasts a single digit decline this year, said: “Prices will continue to fall this year and the lack of mortgages contributes to the negative sentiment.” Lucian Cook, director of research at Savills, the estate agency, said: “This is a bit of a vicious circle. Less mortgage finance means falling house prices, which make lenders more cautious, which they respond to by further restricting finance, which has a knock-on effect on house prices.”