Rate cut will hurt savers and borrowers
The Bank of England has cut the base rate to just 0.5% in March, a move that experts warn will hurt both savers and borrowers.
The central bank’s Monetary Policy Committee has voted for six consecutive monthly base rate cut since October, and the rate is now at an all-time low. Rate cuts are designed to help lower the cost of borrowing for both households and business, thus kick-starting the economy.
However, the effectiveness of this monetary policy is under doubt; apart from concerns that only tracker mortgage borrowers are benefiting from rate cuts, and warnings that prudent savers are being the most severely punished, the economy continues to contract and the recession shows no sign of abating.
In addition, the base rate cannot turn negative and with it edging ever closer to 0%, there is only so much more monetary policy can achieve. As a result, the chancellor Alistair Darling is expected to give the Bank of England permission to introduce quantitative easing – commonly known as printing more money – immediately after the base rate cut.
Impact of base rate cut
While borrowers with loans that track the Bank of England base rate will be celebrating the latest cut, experts warn many more people will suffer as a result.
The Building Societies Association (BSA), a trade body representing the 55 building societies in the UK, says the cut is bad news for savers and most borrowers.
Adrian Coles, director general of the BSA, says lower savings rates will reduce the inflow of money people put in institutions – as a result, banks and building societies will be forced to further cut back their lending operations.
“We need to encourage an increase in the flow of funds into the mortgage market, not take steps that would further restrict that flow,” says Coles.
According to David Hollingworth, mortgage expert at London & Country, the fact that lenders continue to reserve the best rates for people with big deposits or equity stakes is still the major issue affecting borrowers.
“There hasn’t been a radical change in the mortgage market for a year, and people with small deposits continue to face higher mortgage costs,” he explains. “I doubt that rates on new tracker deals will get any cheaper.”
Although tracker mortgages have increased in popularity as a result of the low base rate, Hollingworth believes that fixed-deals will now receive more attention from consumers.
“The base rate can’t get much lower and people are starting to realise that it will have to go up again – possibly very quickly – in the future,” he says.
In a rising base rate environment, fixing may look like an attractive propositio. But because lenders still lack an appetite for lending, they may increase interest rates or fees, or introduce tougher criteria, as a result.
Two new mortgage deals could offer an alternative. “Both Coventry Building Society and Woolwich have introduced tracker mortgages with price caps – this means that borrowers can benefit from any further base rate cuts but also be protected when rates start to rise again,” says Hollingworth.
For savers, meanwhile, the outlook continues to look bleak. According to uSwitch.com, 41 savings providers cut their rates by as much as 1% in the first four days of March alone. As a result, the average variable savings rate is now just 1.08% AER.
The price comparison website warns that the 0.5% base rate cut in March would bring the average savings rate down to just 0.58%, offering a miserly return of £16.32 a year on the average savings balance of £2,813.
Such miserable returns, along with stretched budgets, has already prompted people to dip into their savings – banks report that savers withdrew £2.3 billion from their nest-eggs in January, the first monthly fall in retail deposits since July last year and the largest amount since records began more than a decade ago.
James Caldwell, director at Fairinvestment.co.uk, also warns that the cut will do little to help the economy.
"The latest interest rate cut is just another attempt at reassuring consumers and businesses that the Bank of England is doing something to combat the recession," he explains.
He calls for the central bank to announce quantitative easing measures, which he believes will put more cash into the economy and should have a positive impact on money markets.
"It is clear that more needs to be done to help consumers and small businesses, and only time will tell if quantitative easing will have the desired effect," Caldwell adds.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
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.
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
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.
Where APR is the rate charged for money borrowed, Annual equivalent rate is how interest is calculated on money saved. The AER takes into account the frequency the product pays interest and how that interest compounds. So, if two savings products pay the same rate of interest but one pays interest more frequently, that account compounds the interest more frequently and will have a higher AER.