How to cope with rising interest rates
The Bank of England is in charge of setting the UK's official interest rate - or base rate. It is effectively the cost of securely storing overnight the money it holds for other financial institutions and normally sets the lowest rate that financial institutions are likely to charge customers for borrowing money.
It's a major influence on the cost of mortgages. The higher the base rate, the higher the mortgage rate a borrower is charged and vice versa. This is especially the case for ‘tracker rate' mortgages, which are linked directly to the base rate.
For example, during the credit crunch in July 2007, interest rates were 5.75% and by March 2009 they had fallen to 0.5%. Mortgage rates that tracked interest rates in July 2007 were, on average, 5.98% and as a tracker rate falls with interest rates, they dropped to 1.48%.
But for other rates, such as standard variable rates (SVRs - what a mortgage usually reverts to once any introductory offers have ended) the base rate is only part of the cost. As an example, building societies have to balance the needs of their savers with those of their borrowers.
Reducing the mortgage rate too drastically would result in reducing the rates they could give to savers, which in itself would handicap their ability to lend mortgages, so they can't link all rates to the base rate.
Interest rates and standard variable rates compared
Past interest rates have seen dramatic variations and, in the 1990s, even touched double- digit figures. The figures below give an example of the highs and lows of Bank of England base rates versus Hanley Building Society's standard variable rate for its mortgages. The standard variable rate is the main rate a bank or building society typically charges for its mortgage loans, excluding fixed or capped deals.
|PAST INTEREST RATES||BANK OF ENGLAND BASE RATE||HANLEY BS STANDARD VARIABLE RATE|
|March 2009 to date||0.5%||4.99 to 5.19%|
|Nov 2006 to April 2008||Fluctuated around 5%||5.85 to 7.6%|
|Jan 2000 to March 2008||Fluctuated from 3.5% to 6%||5.35 to 7.45%|
Source: bankofengland.co.uk, thehanley.co.uk
Why is there such a wide gap between interest rates and SVRs?
The table above shows that past margins between interest rates and standard variable rates have varied between 1 and 2 percentage points. Currently, however, SVRs are running at 3 to 5%, meaning they're between 2.5 to 4.5 percentage points higher than the base rate of 0.5%. This is particularly daunting, since if interest rates return to their 2000 to 2007 average of around 5%, then this would result in mortgage rates of as high as 7.5 to 9.5%, levels we haven't seen for nearly 20 years.
Andrew Montlake, a director from mortgage broker Coreco, explains why there is a gap: "Lenders have always set their variable rates based on differing commercial requirements, which encompass the cost of raising funds, the amount of capital they have to put aside, the amount of business they want to keep in their books and the profit they need to make on each borrower."
These can differ from one lender to another. Typically, smaller lenders have higher variable rates as they need to balance the requirements of their savers in order to get the money in to lend out.
"Since the credit crunch, many lenders increased their variable rates and some changed them from Bank base rate-linked variables to ensure they were not caught in a trap of decreasing rates, causing them to lose money as well as helping to restore their balance sheet," he adds.
The big question remains whether they will proportionally increase their variable rates when the base rate rises. Montlake thinks we will actually see the gap shrink again rather than lenders maintaining current differences as "variable rates at 9 or 10% would not be palatable".
Brian Murphy, head of lending of Mortgage Advice Bureau, largely agrees. "As Andrew Montlake explained, the lowering of base rates to an unprecedented level meant many lenders couldn't sustain standard variable rates being aligned with base rates, as any profit disappeared.
Although we can ‘never say never', moving forward, lenders know their current and future customer base can only afford rates which are fair and reasonable. So it's likely that lenders who currently have 5% SVRs may not increase theirs at all as they can still make profit as bank rates increase. And, in reality, moving much higher than this would cause too many affordability issues, which wouldn't be in the lenders or mortgagee's interest."
So the trick is if you are buying or own a home already to make sure you can afford your mortgage payments both now and in the future. This is why, following the Mortgage Market Review, many lenders are now stress testing your borrowing ability should the base rate reach 3% and mortgage rates subsequently move higher to 6%, or even 7%.
What is the forecast for interest and mortgage rates?
At the current base rate of 0.5%, rates for different types of mortgages range from around 2% for borrowers with deposits or equity of 40% of their property's value to 6% for people with a deposit or equity of only 5%.
There are two schools of thought regarding when interest rates will rise. Earlier in the year, most pundits were predicting that rates would start to rise after the next election in May 2015.
However, Mark Carney, the governor of the Bank of England, recently suggested in his Mansion House speech that interest rates may rise earlier than pundits predicted, hinting that might be this year.
This has influenced forecasters' views, many of whom have revised their predictions on when interest rates may rise. The Centre for Economics and Business Research had previously suggested that rates might rise as early as the end of 2014 but now suggests it will be early 2015. Capital Economics' latest forecast suggests a rise in base rates to 1% in 2015.
Peter Spencer, chief economic adviser to forecasting group the EY ITEM Club, explains: "The debate over the timing of the rise in interest rates will help keep the housing market in check – in turn probably holding back the rates hike itself to spring 2015."
It is therefore likely that you might have just under a year before interest rates start to rise, unless there is an economic shock in the meantime. And the main question is, by how much will rates go up? Capital Economics suggests rises to 1% for 2015 and then to 1.5% by 2016.
These rises may appear insignificant but in view of the large sums involved in mortgage loans, even small rises can have a considerable impact on your mortgage costs. As an example, the increase in costs of a £200,000 mortgage loan, linked to increased interest rates, work out as follows: if we take an ‘average' mortgage rate of 3.5%, and this rises by 0.25% (what the first move in base rates could be), your payments will increase from £1,011.23 to £1,038.86 for a 25-year repayment mortgage. That's an extra £27.63 per month, or £331.56 per year.
If we assume the base rate does reach 1% in 2015 and mortgage rates increase by 0.5%, this would result in our case in a 4% mortgage rate. Your payments will increase from £1,011.23 to £1,066.86 for a 25-year repayment mortgage. That's an extra £55.63 per month, or £667.56 per year.
Assuming the base rate settles at the predicted 2% to 5%, and do not revert to their pre-credit crunch average of 5%, this could mean your mortgage rate heads towards 5%. In this scenario, your payments will increase from £1,011.23 to £1,182.54 for a 25-year repayment mortgage. That's an extra £171.31 per month, or £2,055.72 per year.
As far as how these rises will impact on your mortgage payments, this firstly depends on the type of mortgage you have.
The Council of Mortgage Lenders estimated in May 2014 that 89% of new loans for house purchase were fixed. For those on a fixed-rate deal, the lender should not increase the rate until your agreement ends. If, however, this is in the next year or two, it may be worth exploring other types of deal that can offer you longer-term security by fixing your mortgage payments.
These have been particularly helpful for those who have long-term tracker deals, in some cases leading to borrowers paying nothing at all for the mortgage, since the tracker rate was below the base rate. For others, deals of base rate +0.5% or +1% were not unusual as the credit crunch began to bite.
As interest rates rise, however, it is worth examining fixed-rate deals to ascertain whether you could fix your mortgage rates while interest rates find their new level. However, there have been cases, for example, where West Bromwich Building Society and the Bank of Ireland have already increased the rates, despite a tracker in place due to a clause in their contract. It is always worth checking with your lender, broker or independent financial adviser, if you have one, just how robust your tracker mortgage is.
Variable mortgage rates
Predicting what will happen to variable mortgage rates is complex, given how far removed they currently are from the base rate. It is essential to study other deals available at present in order to protect your mortgage repayments from any substantial increases.
Whatever the circumstances, if you are considering switching to another deal, you should make sure that you know what, if any, redemption penalties exist relating to the deals you are switching both from and to, especially if you are planning to move in the next few years.
So if you're concerned about the effect of rising UK interest rates on your mortgage, the golden rule is to start preparing now.
With a tracker mortgage, the interest you pay is an agreed percentage above the Bank of England’s base rate. As the base rate rises and falls, your tracker will track these changes, and so rise and fall accordingly. If your tracker mortgage is Bank of England base rate +1% and the base rate is 5.75%, you will be paying 6.75%. Tracker rates are lower than lender’s standard variable rate (SVR) and as they are simple products for lenders to design, they usually come with lower fees than other mortgage schemes.
A “traditional” mortgage, where the monthly repayments entail of repaying the capital amount borrowed as well as the accrued interest, so that during the loan period the capital debt is gradually paid off so by the end of the term the mortgage has been fully repaid. One advantage of a repayment mortgage is that it removes the risk of having a parallel investment (such as an endowment policy or pension), the performance of which is dependent on the stockmarket, such as with an interest-only mortgage.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.