What affects your mortgage?
Mortgage interest rates are closely linked to decisions made in the wider economy - specifically, decisions taken by the Bank of England.
The Bank of England is the institution that sets interest rates in an attempt to control inflation and deflation and to maintain a stable financial system.
Decisions on interest rates made by the Bank's Monetary Policy Committee are supposed to follow government inflation targets and should in theory lead to stable prices; however the recent economic downturn has resulted in interest rates decreasing to historically low levels in an attempt to maintain a certain level of consumer spending and in turn prop up the country's financial system.
The Monetary Policy Committee sets the base rate every month (on the first Thursday) which is the bench mark for lenders and other financial institutions when setting their interest rates. Interest rates change depending on levels of inflation and deflation. These are affected by a number of things including consumer demand, costs of labour and materials.
Currently interest rates are at an all-time low as a result partially of inflation from recent years but more significantly as a result of banks overstretching themselves and not saving sufficient liquidity levels.
This essentially means that UK banks, similar to those throughout the rest of the world, had been lending out as much money as possible particularly in the property sector, in an attempt to make giant profits through interest.
However, financial systems hadn't accounted for borrowers who were unable to meet repayments. This, in addition to the damaged housing markets, has left major margins between outstanding debts and money coming in.
By reducing interest rates, the government is hoping to reduce monthly mortgage repayments as well as decreasing mortgage and refinance rates for borrowers. This will supposedly free up excess funds to increase consumer expenditure in the long run and therefore rebuild the economic system.
Although most homebuyers think that the Bank of England base rate is the only rate that matters when it comes to the cost of borrowing, it's not. The more obscure swap rates can affect the cost of your mortgage too. These are the rates that banks and other financial institutions pay to borrow from each other.
The swap rate is based on the LIBOR rate – the London Interbank Offered Rate. This rate is published daily and is the average interest rate that major banks in the City charge when lending to other banks. LIBOR is used as the reference rate for interest rate swaps.
Lenders may raise funds on the money markets using swap rates. They can then use them to set the level of interest on fixed-rate mortgages as they can fix the swap rate for a set period of time typically between 1-10 years. The rate they pay is based on the likely average rate of swaps over the fixed number of years they've chosen. They then add their margin onto their costs to pass on to their borrowers. Sometimes swap rates work out cheaper than the base rate.
These fixed-rate mortgages sell out fast which explains why some mortgage offers disappear within weeks. Once the funds the lender has raised on the money markets are allocated to house buyers, they cease to offer that rate and may go back to the market to buy more swaps.
LIBOR can also be used for tracker mortgages. The majority of trackers are based on the base rate plus a certain percentage, but some lenders will base it on LIBOR plus a margin. These more sophisticated trackers are few and far between.
When interest rates drop
When the base rate drops, there are a number of knock-on effects on consumers. For example:
- A reduction in interest rates makes borrowing more attractive, and stimulates the population to spend more.
- It is also likely to reduce monthly mortgage repayments (see below).
- On the downside, a drop in interest rates is likely to reduce people's income from savings.
How interest rates affect different types of mortgages
Changes in the base rate will have a knock-on effect on your mortgage interest rate - either immediately or in the future. Each type of mortgage deal will be affected by base rate changes in a different way. For example:
Fixed-rate mortgage deals have rates that are set for between two to five years typically, though they can be longer.
This means you are locked into that rate for that length of time so it won't change immediately when the base rate is altered. The advantage is that it gives you certainty for the time of your fix but you could miss out if base rates drop during that time.
Of course, any base rate change does affect the interest rates offered on new fixed-rate deals.
In contrast, tracker mortgage rates aren't fixed, but usually have interest rates directly related to the Bank of England base rate.
(Tracker rates can be capped so that they never go above a certain rate agreed at the outset. Alternatively, it can have a collar meaning it can't drop below a certain level, but these are rarer.)
This means that if you have a tracker deal and the base rate goes up, the interest rate on your mortgage is also likely to go up immediately.
And in contrast, if interest rates are falling, it can make financial sense to opt for a tracker rather than a fixed deal.
Standard variable rate mortgages
Every mortgage lender has a Standard Variable Rate (SVR) for its mortgages - which it sets itself. Many of a lender's mortgage deals will be linked to the SVR in some way. For example, a discount variable rate mortgage is usually a lender's SVR minus or plus a pre-set percentage.
When a particular mortgage deal comes to an end, the chances are that you will end up on your lender's SVR, unless you actively switch to a new deal.
In practice, a lender's SVR is usually the base rate plus an extra percentage (added to ensure the lender makes a profit). That means if the base rate rises, SVRs will generally follow suit quite soon afterwards. However, LIBOR also plays a part so if LIBOR rises, it becomes more expensive for lenders to borrow money. This means lenders pass this onto their customers through higher SVRs. Unfortunately, it doesn't always work the other way round. So if base rate and the LIBOR rate goes down, lenders may not pass through the full decrease to their customers.
What to do when interest rates increase or decrease
Lenders generally anticipate what they think the Bank of England will do with base rates, so that by the time they rise or fall the likelihood is that mortgage rates will already have changed.
It's hard to stay one step ahead of the mortgage market particularly as economists rarely agree on what they think interest rates will do and they often get their predictions wrong. The best plan of action is to decide on the type of mortgage deal that's right for you.
Which deal is right for you?
If you'd struggle to cope if your mortgage repayments increased, it makes sense to take out a fixed-rate deal. You'll be pleased if interest rates rise during the time of your fix, but of course, if they fall you could find yourself trapped in an uncompetitive deal as it is usually expensive to get out of a fixed-rate mortgage early.
The main advantage of this type of mortgage is that it gives you peace of mind knowing that your monthly repayments will remain at a set, manageable amount for the length of the deal - no matter what happens to interest rates.
However, if you think you'd be able to cope with changes to your monthly repayments, you could look at a tracker mortgage deal which means you'll benefit from any decreases in the base rate. Tracker mortgages typically follow the base rate by a set amount for a set period of time typically 2-5 years. For example, the rate might be base rate plus 1%.
On the downside, this is a riskier strategy: If the base rate rises considerably, so will your monthly repayments. Check out the difference between rates on offer for tracker and fixed-rate mortgages to give you an idea how much the base rate has to rise before you'll be worse off. Most lenders tie you into their trackers during the period of the deal, but not all of them do so you could always remortgage onto a fixed rate when rates start rising.
Since the credit crunch started in 2008, lenders' standard variable rates (SVRs) have often been the cheapest option so more home buyers have been happy to stick with them. However, thanks to a rising LIBOR rate, SVRs are beginning to go up too and once base rate rises, SVRs will move up even more. But the advantage of SVRs is that mostly they don't have any tie-ins, so you're free to look for a better deal and move quickly.
What to consider when choosing a mortgage
- Are interest rates likely to move up or down over coming months?
- Would you be able to afford an increase in your mortgage repayments if interest rates go up?
- If you're choosing a fixed-rate mortgage, how long are you comfortable fixing for? Remember if you fix for too long and interest rates fall, you could be stuck on an uncompetitive mortgage.
- If you had to get out of your mortgage deal early due to a change in interest rates, would you have to pay an early repayment charge?
It's always a good idea to start hunting for new mortgage deals around three months before your existing deal comes to an end. That way, you're not caught on the back foot and have plenty of time to find the best deal. This is particularly important if you think interest rates may rise in the next few months.
If you find a good deal in advance, mortgage lenders and brokers will often let you lock into that rate while you wait for your existing deal to end. Be aware that you'll probably be charged a small fee for doing this. Don't forget to factor in the arrangement fees which can be high when working out the cost of your mortgage.
- Mortgages are affected by base rate and LIBOR
- Choose a fixed-rate deal if you can't afford for rates to rise
- If you can afford to take the risk, look at tracker mortgages
Mortgage rates are affected by both the base rate and LIBOR