Interest rates are currently at an all-time low. This obviously makes it very cheap to borrow money in the form of a mortgage. However, many mortgagors (borrowers) do not fully understand the influence of mortgage interest rates on the payments they are obliged to make each month.
The Base Interest Rate in the UK is assessed every month by the Bank of England’s Monetary Policy Committee. Many factors are taken into consideration when deciding whether to reduce, maintain or increase it. One major influence is the rate of inflation or deflation. The interest rate is varied to regulate consumer demand; if the rate is increased then goods and services appear more expensive and subsequent demand reduces. This ultimately tends to ensure that price inflation is less likely. If the interest rate is reduced, then prices appear to be cheaper; this is used to stimulate consumer demand.
The other side to fluctuating interest rates is the effect they have on savers. If interest rates reduce, it might stimulate the retail aspect of the economy but investors will be less inclined to place their capital with the banks as the rate of interest the investors receive will be poor. Likewise if interest rates increase, savers will be more inclined to leave money in a savings account because of the more favourable return.
Another influence on interest rates is LIBOR (pronounced Lybor) which is an abbreviation for ‘London Inter-Bank Offered Rate’. This is the interest rate that banks use when they lend money to each other. This rate of interest is announced daily and is determined by the money markets in London. The behaviour of LIBOR can provide the banks with a useful indicator of a forthcoming interest rate change. If LIBOR is significantly above the bank base rate, then it can be a sign that the base rate will increase. If LIBOR is below bank base rate, it might be an indication that the markets feel that the base rate will decrease.
These changes in the Bank of England base rate directly effects borrowers. Mortgage providers (mortgagees) usually arrange Variable Rate loans at around 1%-2% above the base rate. If the base rate goes up, a mortgage is also likely to increase by the same rate. Although this is not ‘set in stone’; it is up to the mortgage provider to pass on reductions or increases.
A Fixed Rate mortgage is often used by landlords, as it is very easy to budget and plan for repayments into the future. Landlords that have access to this facility are often recommended to fix the rate for as long as possible e.g. If this term is 25 years; then that’s 25 years of mortgage repayments that will not change over time. Although in practice, it is highly unlikely you will find a mortgage provider that provides this for a period longer than about 5-10 years.
A Tracker Rate mortgage will closely shadow the base interest rate and stay around 2%-3% above the base interest rate. This allows the borrower to take advantage if the interest rates drop, though it will get expensive if the interest rate increases by a great deal.
On a typical repayment mortgage, the borrower pays a particular sum each month which covers a percentage of capital but is mostly made up of interest (though this ratio will change as the term of the mortgage progresses). So for example, if a total monthly mortgage payment is £1,000, this might comprise £750 in interest and the remaining £250 goes towards paying off the capital. The amount of interest paid depends upon the amount of the loan still outstanding and the interest rate applied to it. The capital portion of the repayment depends upon the amount borrowed and the term of years the mortgage is to be repaid back over (for example 20 years). So if a borrower makes overpayments, this reduces the capital aspect of the loan far quicker and therefore substantially shortens the mortgage term and therefore the total amount of the mortgage.
The following tables offer illustrations to compare the effect on monthly mortgage repayments when the interest rate varies. Far too many property speculators and conventional homeowners do not consider the effect that a substantial rise in interest rates would have.
These tables show the difference that a significant change in interest rates would have on mortgage repayments. Almost all mortgagors would experience difficulty to some degree if rates increased, however some element of flexibility should always be considered.