Would it be so bad if interest rates increased?
by Ben Salisbury
Those with a variable-rate mortgage have been basking in the sun, financially speaking, for nearly two years but they should change their status to high alert now and think about their options if interest rates do go up.
The pressure from commentators and financial institutions to raise rates has gone from a mild murmur to a dawn chorus and although the Bank of England’s Monetary Policy committee (MPC) has so far resisted the calls it might not for much longer.
Slashing base rate as dramatically as the bank did in early 2008 was certainly the right call at the time and saved a very tough recession from causing even more collateral damage to companies and homeowners, reducing job losses and repossessions as it did.
However, there is a good argument that says the low rates have gone on for long enough as savers and pensioners are punished. Last week the MPC voted against raising rates yet again, but that was followed this week by new figures showing that inflation has hit an eight-month high of 3.7 per cent which represents the biggest single month increase since records began.
The Bank of England only has one tool in its armoury to combat inflation and that is interest rates. Rising food and oil prices makes it seem as if inflation is increasing more quickly and to higher levels than it actually is, though it is important to remember that the retail price index (RPI) is running at 4.8 per cent and this measure includes housing costs.
Fixed or variable?
But what does this mean for those with a mortgage? In short, if you have been sitting on a variable deal and enjoying the benefits of lower repayments, it may be time to transfer to a fixed-rate mortgage.
There are still some excellent variable deals around, and there will continue to be for as long as there is no change to base rate because the interest rate attached to these deals will rise in line with any rise in base rate. This is likely to be soon, so perhaps it is time to find a good fixed-rate product.
If you are already on a fixed rate then you are limited in your options because you are likely to face heavy financial penalties for moving. Anyway, the best time for switching to a variable rate looks to have passed.
There are still variable deals available at around two per cent or slightly higher so another alternative is to take a two-year variable deal and hope that the bank raises interest rates gradually and that inflation responds to this measure so that the Bank of England don’t have to raise rates quickly or to high.
Otherwise there are scores of two-year fixed-rate deals available at around three per cent, plenty of three-year deals at around four per cent and lots of five-year fixes around the five per cent mark.
These products didn’t look very attractive even four months ago but the dynamic around interest rates has changed a lot in the last few months and it is very possible that these rates will look good in six months time, and if interest rates go up as regularly as some commentators expect they could look more attractive with every month that passes in 2011.
Use the Myfinances.co.uk best buy tables and comparison tools to find the best deal on a mortgage.
Effect on savers
We all feel the effects of inflation in higher food, petrol and energy prices but the effect on savers is particularly harsh. Encouraged to be prudent with their money, savers are receiving no benefits for the sensible housekeeping of their finances.
Indeed, a basic-rate taxpayer needs to earn 4.63 per cent gross on their savings just to keep up with inflation, let alone receive any financial benefit. A higher-rate taxpayer has to earn 6.17 per cent. Neither of these returns is possible, so their savings are losing value. Raising interest rates would send a message to savers that all is not lost and a warning to borrowers that low interest rates are the exception rather than the norm.
Effect on pensioners
Pensioners receive a particularly hard deal when inflation is high. Firstly, the state pension does not go up in line with the rate of inflation, and secondly, the proportion of pensioners who receive index-linked private pensions - pensions that rise in line with inflation - is very low.
Pensioners spend the majority of their money on essentials such as heating and food and these are the areas that rise fastest when inflation goes up.
Read more: Best types of mortgages for different buyers
Pay more to get a safer economy
All commentators and interested parties, including the MPC, know that interest rates have to rise sooner or later. If the VAT rise, higher fuel and commodity prices and job losses combine to make inflation continue to rise then the Bank of England could be forced into dramatic action by raising rates higher and faster. This could have a devastating effect on many homeowners and lead to an increase in repossessions.
However, if the bank raises rates by a small amount and at a steady pace, the shock to those with a mortgage will be lessened, people will have the ability to manage the increases and savers and pensioners will be placated. So, perhaps a small dose of medicine will lessen the need for major financial surgery from the Bank of England and the nation’s finances.
Is it a price worth paying?
The Bank of England has a very tricky decision to make. If you have a mortgage of £150,000, a rise in interest rates of 0.25 per cent will mean you pay an extra £32 on your monthly mortgage.
However, inflation is costing most people that amount in higher prices for fuel, energy and food. So, if a small increase in interest rates (or a few small increases over the course of a year) served to lower inflation, we would all benefit to some degree.
A mortgage alternative
We have looked at fixed-rate and variable deals earlier in the article, but one other mortgage alternative that could be appropriate is a deal where you take a tracker now and then move to a fixed-rate deal when interest rates go up.
This means you can enjoy the benefits of low rates while base rate is low but then benefit from the safety of a fixed-rate deal, which isn’t dependent on the movement of base rate when it does start to go up.
These mortgages are known as ‘term trackers’ and most come without an early repayment charge, giving you the freedom to move to a fixed rate from any lender at any time.
Use the Myfinances.co.uk best buy tables and comparison tools to find the best deal on a mortgage.
Comments
Newsletter sign up