Why are fixed rates falling while the base rate is rising?

Although we are seeing the Bank of England base rate rise, that does not necessarily mean that mortgage rates will too. To help clarify things, we’ve put together a beginners guide to how they work.

The simple answer is because inflation is still rising beyond acceptable levels, but swap rates are reducing. But this means nothing unless you understand the context, so let’s start there!

Broadly speaking, there are two main types of mortgage product:

 

• Variable rates

The term “variable” encompasses any type of product where the interest rate you pay can change over time; such as tracker rates, discounted rates and similar products.

 

The basics

Woo: The great thing about these mortgage products is that your monthly payments will reduce whenever rates fall.

Boo:  The risk that these products bear is that there is often no ceiling on how high they can increase, should rates rise. Meaning there is no certainty over how much your monthly mortgage payments will cost. Difficult if you’re on a fixed income.

 

How are they set?

Generally speaking, these interest rates tend to follow the Bank of England base rate (BBR for short). Please note though, this is not always the case, so it’s worth checking your mortgage fine print to know for sure.

For example, if a lender offered you a rate that tracks say, 2% above the BBR, you’d currently be paying 5% for that mortgage – as the BBR is 3% at the time of writing.

But if the BBR increased to 3.5%, your mortgage rate would increase to 5.5%. Likewise, if it fell to 2.5%, your rate would go down to 4.5% to match.

 

When can I expect variable rates to change?

The BBR is reviewed and set every six weeks during a meeting by the Monetary Policy Committee (MPC). When they’re deciding how to set the BBR, they will consider their primary goal- which is to keep inflation at 2% and sustain growth and employment in the UK.

The Monetary Policy Committee will increase the BBR if they feel that inflation (rising prices; best explained here) is too high. The MPC knows that if interest rates are higher, it will deter people from spending too much, as both individuals and businesses will face higher borrowing costs. They’ll keep more money in their pockets, which will in turn drive the costs of goods and services in the UK down. So the MPC uses the BBR as a way of calming the rate of inflation if it’s rising too quickly.

Similarly, if the MPC want to encourage spending, they’ll reduce the BBR.

So, it would be logical to say that you can generally expect variable mortgage rates to rise and fall as inflation does.

 

 

• Fixed rates

Fixed rates mean that you’ll pay a guaranteed set amount of interest for an agreed period of time. Usually you’ll agree a fixed rate of 2, 3 or 5 years with a lender, although you can sometimes get longer terms than this.

The basics

Woo: The nice thing about fixed rates is that they offer you certainty over how much you’ll have to pay each month. And, no matter how high interest rates rise, your payments are unaffected.

Boo: The drawback is if rates go down, your payments will still remain the same. You can’t move onto a better deal before the end of the term without paying (often quite hefty!) exit fees to leave your current mortgage deal first.

 

How are they set?

Fixed mortgage rates are largely determined by something called swap rates. Simply put, the money that mortgage lenders lend to us via mortgages is usually money that they themselves have borrowed from investors and other banks. And the interest rate that they pay to these investors  for that borrowing is called a swap rate.

Lenders usually tend to borrow the money from investors over two, three, five or ten year periods. Which mirrors the typical fixed rate periods that lenders offer to their customers.

Deciding swap rates includes a lot of guess work. When an investor is deciding how much interest to charge a mortgage lender for say, a 2 year tranche of money, they’ll look at what’s going on with the economy and with government borrowing, and then try to predict what they think these things are going to do for the next 2 years.

If they think that things like government borrowing are going to become more expensive, they’ll set a higher swap rate, and vice versa. That way, they can be confident that they’ve set a swap rate for the mortgage lender that should guarantee the investor will make a profit from the lender over those 2 years.

 

When can I expect fixed rates to change?

Fixed rate mortgages increase when swap rates do. If it costs a mortgage provider more to borrow money from banks and investors, mortgage providers will increase their fixed rate mortgage deals to match.

One thing that very closely influences swap rates is government borrowing. The more expensive it is for the government to borrow money, the more expensive it is for lenders to borrow money to provide us for our fixed rate mortgages.

So generally speaking, you can expect fixed mortgage rates to rise and fall in line with swap rates as well as government borrowing (see gilts). There are other factors too of course, such as if a mortgage lender is keen to undercut their competitors to attract more customers. They may also bump up their rates if they’ve experienced a sudden influx of new mortgage applications in order to deter more people from applying.

 

Putting it all together

Knowing all of this can help in deciding which type of mortgage deal to go for. As being armed with the knowledge on how rates are set by lenders allows you to do some research into where those interest rates may go in the future, before choosing your next mortgage deal.

But there is more to it than just that. You’ll also need to consider how these products affect your own lifestyle and finances, as well as your attitude to risk.

The best way to make sure that you get the right deal for you is to get a personalised recommendation from a qualified adviser, who can assess your individual needs and preferences and match you up with the right deal.

If this has got you thinking or worried, we’re here to help.   Get in touch and we’ll talk you through your options, wherever you are in the UK.  Or sign up to our monthly newsletter, to keep your finger on the pulse.

Helen Peel – 18th November 2022