Discount-rate mortgages - the future or past?

With interest rates odds-on to rise next week, the time for discount-rate mortgage deals could be now.

In times of rising interest rates consumers tend to flock to safety and opt for fixed-rate deals to try and protect themselves from future increases.

But this could prove a costly mistake.

When mortgage providers decide how much they are going to charge people taking out fixed-rate home loans, they look at the market expectations of where interest rates will be in the months and years to come.

This means taking out a fixed-rate mortgage in today's market - when rises are expected - is effectively paying now for possible interest rate rises to come.

And the market is frequently wrong.

In summer 2005 the market expected that interest rates would fall, and began offering fixed-rate deals priced lower than the Bank of England's base rate. In fact interest rates stayed steady for a year and then rose in August this year.

Similarly, in late 2004 analysts believed interest rates were set to rise to 5.25 per cent - when in fact they stayed steady at 4.75 per cent for 12 months then fell.

As such in a climate of rising interest rates fixed-rate deals generally only offer good value over the entire period of the fix if rates rise at least twice and stay that high over the fixed-rate period.

By contrast, discount-rate mortgages can protect people from the actual changes in the market, without over-charging people before rates actually rise and again if they fall.

A discount-rate mortgage offers a discount on one of the lender's other rates - often their standard variable rate - which will typically change broadly in line with the current Bank of England base rate.

For example, if a lender's standard variable rate is six per cent for the period of the discount, borrowers may be able to benefit from a rate of four per cent (assuming a two per cent discount rate). If the standard variable rate falls by 0.25 per cent to 5.75 per cent, the discounted rate will also fall 0.25 per cent to 3.75 per cent.

Currently there are very few fixed-rate mortgages on the market offering less than five per cent (which is what interest rates are expected to rise to on Thursday).

At the same time there are discount-rate mortgages offering rates lower than 4.5 per cent.

While these rates will rise if interest rates do increase, they will also fall if interest rates are cut.

And the market expectations are that rates will fall in the future, with interest rates trading as low as 4.25 per cent over a long-term (30 year) horizon.

While few people take out fixed or discount-rate mortgages over this length of time the market is predicting that rates will be as low as 5.26 per cent in three years' time and fall further after this.

With a discount-rate deal over five years this means there will only be a limited time where someone on a 4.5 per cent discount rate mortgage will pay more than someone on a five per cent fixed-rate deal - and even then only by 0.1 per cent – and large periods of time when their payments will be lower.

As such, the time to take out a discount-rate mortgage could be now. XXX