Mortgage rates set to rise
The boom days of the last decades are well and truly behind us. During the 80's and 90's we saw a tremendous growth in the number of financial services institutions that started to offer mortgage loans. We also saw the introduction of new products such as fixed term loans and offset mortgages in an attempt to attract new customers. This competition and capacity in the market place helped to stimulate the property market and to keep rates down. As inflation dropped, so too did underlying interest rates and the feel good factor, never ending feeling resulted in a frenzy of mortgage lending.
With changes to the pension system introduced during Chancellor Brown's first budget in 1997, it became apparent to many that a traditional saving plan would not generate sufficient funds to bring a quality retirement. As a result, a new breed of investor saw the opportunity offered by rising house prices to supplement their pensions by buying property. The buy to let market grew as people took advantage of low or no deposit mortgages and started to become landlords or property developers/speculators.
Sadly, that has all passed us by. The financial markets collapse, started by the property market failure and poor lending on property in the US (and UK!), has led to a catastrophic shift in the number of players prepared to offer funds in the lending market. Despite government attempts to encourage the now largely privatised domestic players to start lending again, there is simply not the appetite or market conditions to allow them to do so with comfort. 'Comfort' here means that have an ability to reasonably predict property prices (as the underlying security behind the loan) and that the recession will not lead to default caused by job loss.
Therefore, we have a number of factors emanating from the recession and financial markets meltdown that make lenders cautious to lend in a falling market. In addition, their profitability has been severely eroded to the extent that they have to focus on profitability. One of the ways to do this is by focusing on the lowest risk categories of customers and increasing their spreads (the margin between what it costs them to raise the funds in the wholesale markets and the rate at which they then lend those funds to you and I in the retail market). Therefore, those customers with large deposits and good credit histories have been able to apply for and get mortgages at attractive rates. Those with little or no deposit have suffered a significant rise in rates charged and those with poor credit histories have not been able to get a mortgage at all – no matter what the rate.
All the lead indicators seem to show that house price falls have stopped and that the recession appears to have passed its worst. There may even be a hint of economic growth within the next few months although unemployment will continue to rise.
So, as markets stabilise and the outlook becomes more certain, the focus will turn on stimulating economic growth and controlling inflation. Pent up demand and confidence has, in past recessions, led to increased consumer spending that has fuelled inflation. The remit of the Bank of England is to keep inflation below 2% per annum – something that has been very hard to achieve in recent turbulent times. The sole weapon that it has at its disposal is interest rates. Raising interest rates increases the cost of borrowing and reduces disposable income. Therefore, people have less to spend so demand drops. As demand drops, inflation falls. Well, that is the theory!
The problem for mortgage borrowers is that they are looking to take loans over long periods. The traditional variable rate mortgage is one where the interest charged on the loan balance changes to reflect the underlying Bank of England base rate – or a tracker rate closely aligned to it. Therefore, as rates rise, mortgage rates rise and payments increase. With consumers used to low interest rates, a rise of 2% or 3% can make a material difference to the monthly mortgage payment.
To combat this, many customers have moved to fixing the rate of their mortgage for a period of time – usually 2 to 5 years. This takes away any variation in rate for that period. This makes any refinancing at the end of the term subject to market rates at that time – a huge uncertainty in itself.
There is no doubt that rates are set to rise. Fixing can alleviate some of the pain but the initial rate will be high to reflect the future anticipated rate hikes. Certainty may be preferable to running the risk of runaway interest rates.