Five things you need to know about mortgage rates
Published: 31 July 2015 | Author: Sue Anderson
If you're a seasoned player in the mortgage market, you'll understand that Bank rate is just one influence on mortgage rates - and you'll know what to do if and when mortgage rates rise.
But spare a thought for well over a million first-time buyers - and a fair number of industry professionals - who have never yet experienced a rise in Bank rate.
With this in mind, given the Bank's strongest hints yet that a rise might actually be on the cards from the turn of the year, we thought now might be a good time to put the spotlight on some of the influence and questions that hover around mortgage rates.
Here are five things you need to know - some fairly obvious, others perhaps less so.
1. The Bank rate is not the sole influence
It's often assumed that there is some kind of umbilical cord between Bank rate and mortgage rates, but this is not really true (other than on Bank rate tracker mortgages, of course). Bank rate is a huge influence on UK interest rates generally - so it tends to have a feed-through effect to mortgage rates. But the relationship is neither clear-cut nor entirely predictable - not least because the Bank rate does not represent the actual costs faced by individual lenders, at any point in time.
Chart 1: Typical new mortgage rates relative to Bank rate
We can see this demonstrated in practice by the fact that Bank rate has remained static for the past six years, yet mortgage rates have continued to fall. New mortgages have continued to be repriced as funding conditions for lenders have improved, competition has increased, and confidence in the economy has strengthened, reducing the perceived risk of defaults.
2. There are numerous inter-connecting factors affecting mortgage rates
It's tempting to think that a quarter point rise in Bank rate would automatically mean a precise quarter point rise in other interest rates, including mortgages - right? Well, not necessarily.
Although there is a relationship between Bank rate and wider interest rates, there are also many other influences on the pricing of a mortgage. Changing the Bank rate can set off a whole chain of other reactions that affect the may affect pricing of mortgages both directly, and indirectly.
These might include:
- The individual lender's own cost of borrowing funds - from savers, from banks, from wholesale market investors (and by securitising mortgage assets - recent securitisation issues, it is reported, were affected by the turmoil in Greece). This will differ week by week, lender by lender - and there is no "one-size-fits-all" source of information on the aggregate industry mixed cost of funding.
- The lender's costs of managing the risks that are inherent in borrowing-to-lend - the risk of interest rates on their borrowing falling out of sync with the interest rates on their lending, among other things. (See our new articles on the yield curve and swaps).
- The level of riskiness of the lending - hence the likely level of default. Other things being equal, higher rates mean higher risk as borrowers are more stretched. Yet, higher rates might also mean a healthier economy, better employment prospects etc, which might mean lower risk.
- The lender's cost of holding the required level of capital to offset the risk in its lending - this will vary depending on the type of lending, and market conditions.
- Individual product design - rates need to be seen alongside fees, when considering the overall pricing of a mortgage. Product design will be influenced by consumer preferences, competition, and a lender's experience of the relative take up and popularity of different products.
- The lender's target level of surplus/profit in undertaking its lending. Profitability is an important consideration and one that does not need apology; if lenders are not profitable, then they become unstable, and the whole economy suffers. However, competition is an extremely effective mechanism to ensure customers get good deals and to prevent profit from becoming excessive at their expense.
3. Even when they rise, rates will still look incredibly low by historical standards
It barely needs saying that rates are extremely low, and unlikely to return to their historical average any time soon.
Chart 2: Average interest rate on new and existing mortgages
You don't need to take our word for it; Bank of England Governor Mark Carney said last week that since the Bank's inception three centuries ago, short term interest rates have averaged around 4 1/2 per cent, but that "it would not seem unreasonable to me to expect that once normalisation begins, interest rate rises would proceed slowly and rise to a level in the medium term that is perhaps about half as high as historical averages."
For anyone who remembers paying a mortgage at 14% or 15%, it's relatively easy to contextualise our current rate scenario as an aberration - albeit a six-year aberration - from the norm.
But for well over a million first-time buyers who have entered the market since Base rate settled stubbornly on its 0.5% level, the prospect of higher rates will not feel "normal" - as Sunday Times financial journalist Anna Mikhailova recently described in a personal capacity.
Still, the overwhelming majority of them will cope, by flexing and juggling their finances in the way that YouGov has previously observed as a typical UK consumer response to changing financial circumstances.
4. Around half of existing mortgage holders and 90% of new mortgage borrowers won't initially be affected by rising rates, as they're on fixes
How higher rates may impact on these mortgage customers will depend on what the rate environment looks like, and what the prevailing pricing of mortgage products is, when existing fixed rates eventually reach the expiry of their fixed period.
Chart 3: Proportion of new and existing loans on fixed rates
With various tranches of business all expiring at different times and reverting from different rates, it is clear that the effect of higher rates on existing fixed-rate mortgage customers will be staggered. The instant effect of rate rises will not be felt in the mortgage market universally, in the way that it used to be in the 1980s or early 1990s when most customers had variable rate loans, and felt the effect of any rate change in their next or next-but-one monthly payment.
Even so, Mr Carney noted (in the same speech) that:
"Over a half of UK mortgagors would pay higher rates in a year’s time, and close to three-quarters of mortgagors in two years’ time, were interest rates to evolve according to current market rate expectations. That is in stark contrast to the US, where even over a two-year period, less than 10 per cent mortgages would be affected directly by a change in rates. We will learn more about the importance of these sensitivities as interest rates increase."
5. Consumers tend to be short-termist - their current enthusiasm for fixed rates may not be permanent
But what will new customers do, and what kind of products will they choose? It is interesting to note, as Moneyfacts has, that in recent months the rates charged on some fixed rate mortgages have been lower than the rates charged on variable rate trackers over the same deal period.
This raises the question about whether the current overwhelming preference of UK consumers for fixed rates reflects the attraction of price, or of certainty, or both. Would it persist, if a higher rate differential between fixed and variable rate products began to emerge?
If so, this would indicate a significant sea change in the UK consumer mindset. In many countries, consumers see it as entirely rational and normal to pay a higher rate for the payment certainty of a long-term fixed rate. But in the UK, this has not typically been the case - in interest rate terms, consumers have tended to opt for "short term gain", and accept the risk of "long term pain" (although in practice that risk has not generally been realised; indeed, in the past those who have opted for longer-term fixed rates have often found themselves at a disadvantage as rates continued falling).
Recent research from the agency ESRO, on behalf of the FCA to underpin its thematic review of mortgage advice, would tend to suggest that short-termism is still a predominant feature in consumer thinking.
The researchers comment:
"…we found consumers to be optimistic about future product availability, expecting comparable or cheaper products to be available when they next move or remortgage. This means that many consumers are also confident in their ability to rectify any compromises they have made to get their current mortgage, and target monthly repayment amount, through their future mortgage choices.
"Due in part to this confidence in their future financial situation, and the future mortgage market, consumers are reluctant to lock in for long periods of time for fear of missing out on future offers. Current consumer behaviour (across all types) is very much driven by the search for the best initial ‘deal’. Despite regarding a mortgage as a significant (if not the most significant) long-term financial commitment they are likely to make, consumers’ choices are nonetheless predominantly short-term, thanks to high levels of certainty that they will move from one product to another throughout their time in one property, or over the course of their home-owning lifetime."
Mortgage rates look set to be a hot topic of conversation - and perhaps, for some customers, anxiety - over the coming months and years. People will want to try to understand what influences mortgage rates, and why mortgages are priced as they are.
Although this article only skims the surface - and our other jargon buster articles on swaps and the yield curve are designed to be read alongside - it is very difficult to unpick and calibrate all the many and various influences on rates. The key point is that rates are influenced by a whole raft of factors - and that Bank rate is only of them, albeit an obviously important one.