Mortgages, banks and interest rates

28 March 2008

Once you’ve decided that home ownership is the way to go, you’re faced with another big decision: selecting the mortgage deal that’s right for you.

But for most of us, buying a house is something we’ll only do a few times in our lives, so there’s no way we can follow all the pros and cons of the different mortgages on offer. Online comparison sites and similar publications are useful, but it’s often much simpler and much better to go to the experts (mortgage brokers/advisers), explain your situation and see what they recommend.

Before you do that, however, here are a few interesting things to think about...

The base rate
The base rate set by the Bank of England (BoE) is the ‘benchmark’ for interest rates throughout the UK. It’s never a good idea to choose a mortgage until you understand where the base rate is headed – and how this can affect your payments.

• In July 2007, the base rate reached 5.75%.
• Today, it’s down to 5.25%.
• Many experts expect it to drop below 5% by the end of 2008.

But the base rate can change rapidly and unexpectedly – once, in 1985, it leapt from 9.5% to 13.88% in about two weeks. Even though that was in response to highly unusual conditions, it shows that it can happen.

How does the base rate affect mortgages?
In theory, when the rate goes up or down, so does the cost of some loans and mortgages (but not all – see below). So in 1985, some homeowners saw their mortgage payments shoot up around 40% almost overnight.

But banks aren’t always obliged to follow suit. If the base rate drops by 0.25%, for example, a bank might reduce the cost of some mortgages by the same amount. This is a good way to attract customers, but that’s not always their top priority. If they’re more concerned about protecting their cash reserves, they might reduce their own interest rates by 0.20%, or 0.10% – or nothing at all.

Fixed rate, Variable rate and Tracker mortgages
In terms of interest, there are three basic kinds of mortgage – Fixed rate, Variable rate and Tracker – and each has a different relationship to the BoE’s base rate.

The simplest of these is the Fixed rate. As the name indicates, the interest rate you sign up to at the start of the mortgage will remain fixed for an agreed time, after which you’ll probably start paying the Variable rate (or choose a new mortgage). A Fixed rate mortgage provides the stability that many people need, whether they’re paying off debts through a debt management plan, saving for the future or simply on a tight budget.

With Tracker mortgages and Variable rate mortgages, the rate you pay will change over time. The difference is that Tracker mortgages automatically follow the changes in the BoE’s base rate, while Variable rate mortgages only follow at the banks’ discretion.

So when people think the base rate is on the way up, a Fixed rate makes sense. 77% of the mortgage deals last June / July were Fixed, according to the Council of Mortgage Lenders (CML).

But today, with the base rate expected to keep dropping, Tracker mortgages are becoming more popular – the CML reports that only 57% of January’s mortgage deals were Fixed.

Which mortgage is right for you?
It all depends on your situation: not just what you owe and what you earn, but how stable your circumstances are and how much risk you can handle.

If you can make your mortgage payments quite comfortably, you might choose a Tracker mortgage, so you can benefit from the base rate cuts the experts are predicting.

If, on the other hand, buying a house is really stretching your finances, it might make sense to look at a Fixed rate mortgage. It might be irritating to miss out on the expected base rate cuts, but what would you do if the experts turned out to be wrong? If your mortgage payments suddenly jumped by 10% or 15%, would you be able to cope, or would you find yourself seeking immediate debt help to stop your house being repossessed?

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Gregory Pennington are founder members of DEMSA (Debt Managers Standards Association).

DEMSA are the first trade body within the finance industry to successfully secure approval for its code of practice under the OFT Consumer Codes Approval Scheme (CCAS).