The only way is up
In recent months, there’s been a lot of speculation about the inevitable rise in interest rates, but what will it really mean for your finances?
Borrowers with mortgages on variable interest rates can breathe a sigh of relief as the Bank of England yesterday held the base rate at the historic low of 0.5%, where it has remained since March 2009. On the flip side, cash investors continue to wait for any improvement in returns.
Whilst we won’t know the details of yesterday’s vote for a couple of weeks, we do know that in August, two out of nine Monetary Policy Committee members voted for a 0.25% rise in the base rate.
This is probably a sign of things to come given the wider economic recovery, although when exactly there could be a majority vote for a rise, no one can be sure. However, the end of this year or next year seems to be the general consensus of the markets. And when it does happen, the Bank of England tells us that rises will be ‘slow and steady’.
But with all the speculation, it’s important to put the impact of any interest rate rise into context where your personal finances are concerned, as it will affect everyone differently.
The focus of most interest rate stories is the impact on mortgage rates. And understandably so, as for the vast majority of people, this is their highest monthly outgoing and financial priority above all else.
If you are on a variable interest rate, then there’s a good chance are that you’ve done pretty well out of the long term, low interest rate environment. That is, you haven’t locked yourself into a higher fixed rate unnecessarily.
Of course, when the base rate eventually increases then it stands to reason that you’re likely to see an increase in your monthly repayments. For a tracker product, an increase is guaranteed whilst for other variable rates (e.g. a discounted rate or Standard Variable Rate), an increase is not guaranteed, but is highly likely.
In fact, for variable rates other than trackers, lenders can change rates at any time they wish, regardless of the base rate movement. So you could see an increase ahead of any base rate rise, as some lenders already have done in anticipation.
There are many homeowners that have bought their first property during this historical static low for interest rates, and so have never experienced an interest rate rise. So let’s look at what an increase could actually mean.
A £150,000 mortgage with a 20 year term remaining, on a tracker rate of 2.99% (base rate plus 2.49%), would see an increase in repayments of nearly £20 per month from a 0.25% increase in the base rate.
Whilst that may not seem much, if increases were to continue ‘slow and steady’ (e.g. at 0.25% every quarter) then within a year, monthly repayments in this example would increase in the region of £70-£80 per month. And if the base rate continues to rise over a number of years (as the markets expect), the increases in repayments would become even more pronounced, hence the attraction of a fixed rate.
However, unfortunately no one knows for sure when interest rates will rise, by how much, how quickly or for how long. So a variable rate could still have value, depending on how these factors play out in reality.
If you are on a fixed rate when the base rate increases, then it’s not going to impact your monthly repayments until such a time as your fixed rate period ends and you either look for a new fixed rate or go on to the lender’s Standard Variable Rate.
Of course, if your fixed rate is due to expire in the near future and you want to secure a new fixed product, then it’s worthwhile thinking ahead so you can align this to the end of your current deal.
If you’re currently on a fixed rate that you want to end so that you can secure a more competitive deal, then you’re likely to incur an Early Repayment Charge (ERC). This is a charge by the lender to recoup the cost of you ending the mortgage contract within the promotional period. ERCs can be substantial (1%-3% of the mortgage balance is typical, depending on the remaining promotional period). Therefore, this must be weighed up against the saving in repayments that could be made by switching to a lower rate, alongside the potential other remortgaging costs such as booking fees, arrangement fees, etc.
Regardless of what type of mortgage rate you have, whenever you are looking for a new deal, it’s important to look past the interest rate in isolation and compare the overall cost of repayments, setup fees, exit fees, etc. so that you fully understand the most cost effective option that suits your needs.
Whilst simply changing products with your current lender will generally incur less fees than switching to a new lender, if the overall cost of paying a fee to switch to a lender with a lower rate works out cheaper overall, then it’s worth consideration.
And a word of warning on comparing the APR (Annual Percentage Rate) for mortgage products. The APR is designed to be a representative interest rate for consumers to compare the overall cost of different lenders’ products, because it accounts for interest and fees. However, the APR makes two unlikely assumptions where mortgages are concerned:
- That interest rates won’t change over the term of the mortgage
- That you will keep that mortgage for the full term
Because of these limitations, you are better off comparing the rates and fees over a more realistic timescale, e.g. the total cost of repayments and fees over the period that you intend to have the product (e.g. three years), before reviewing again.
To fix, or not to fix?
That is the question. And the answer is… well, it’s a personal one. It depends on your circumstances and attitude to risk. Ultimately, are you comfortable with your monthly repayments increasing, and if so, to what extent?
If you’d rather the security of knowing your monthly repayments are fixed for the next two, three, five years or so, then now might be the time to consider reviewing your mortgage and moving to a fixed rate product. A number of fixed rate deals have already increased this year in anticipation of a base rate rise, although there are still some competitive deals out there, with some lenders even reducing fixed rates.
However, bear in mind that if rates don’t increase as expected, then you will likely be paying a higher interest rate (and possibly higher fees) for fixing your rate over a period where rates remain constant.
Alternatively, if you’re happy to go with the ebb and flow of the economy and can afford to make higher repayments as rates rise, then choosing a variable rate is a perfectly reasonable decision. It could be that the savings that you have made from the low rate environment allow you this flexibility, and that you are comfortable with the predicted ‘slow and steady’ increase in rates.
Just remember that nothing is guaranteed, and reality could turn out to be different to even the best economists’ predictions.
Poor old cash investors – the other side to the interest rate coin.
Over the last five years or so, interest rates for cash savings on the high street and elsewhere have certainly been nothing to get excited about. In fact, in real terms (against inflation) cash investors have usually seen the value of their savings eroded somewhat.
Clearly, that could be set to change as both interest rates and inflation settle to more ‘normal’ conditions, but it could be some time before we see interest rates that provide inflation-proof returns.
Therefore, think carefully before locking money away in a fixed interest savings product, which may offer preferential interest rates in today’s terms, but may not in one, two, three years, etc. There are likely be penalties on withdrawing money mid-term from such products, and so it could be worthwhile sacrificing what is potentially a small amount of interest at this time to have access to your savings to reinvest, should rates increase and more competitive products launch.
And whilst we’re on the subject of cash savings, don’t forget that you can now pay up to £15,000 per year into a NISA (New ISA), which replaced all existing ISAs in July. The limit for cash ISAs before this was £5,940 per year. So, if you pay income tax then using a NISA for your cash savings will prevent any tax being paid on interest from your savings, regardless of interest rates now or in the future.