VARIABLE OR FIXED?

In January, the government announced the biggest jump in inflation since records began and triggered rumours of interest rate hikes. As market uncertainty increases, Laura Edgecumbe asks what ftbs need to know about interest rates before taking out a mortgage

The governor of the Bank of England
recently wrote to the chancellor, Alistair Darling, to explain why inflation had risen above the government target of 2%. Press headlines suggested interest rates and mortgage payments would rocket as a result, and a variety of economic predictions followed.

For the most part, commentators say the trend is towards an increase in interest rates.

Emba Group sales and marketing director Mike Fitzgerald says: "The low-rate party is nearly over, and there is a strong expectation that rates will have to rise to make sure inflation stays dead. The underlying trend will be one of rising rates… we can't stay this low for ever."

And Andrew Montlake, from mortgage broker Coreco, urges borrowers to exercise caution.

"This is a real shot across the bows for borrowers, many of whom are quietly banking on a low interest rate environment in the short term," he says. "But this is a risky game to play. If rates do indeed rise to contain inflation, many borrowers will find themselves with significantly higher monthly payments."

Others, however, are less pessimistic. European economist Azad Zangana believes: "While the latest inflation estimates are a surprise, we do not expect the Bank of England to panic and raise interest rates."

And there are some who believe interest rates will stay low in the long term, such as Roger Bootle, managing director of Capital Economics, who forecasts that base rates will not exceed 1% over the next five years.

Perhaps a reliable consensus can be taken from the Bank of England's November 2009 Prospects for Inflation report. The report implies that the base rate will potentially rise to 1.6% in 2010, to 3.2% by the end of 2011 and 3.9% by the end of 2012.

Borrowers should consider all eventualities and avoid opting for the cheapest mortgage rate without assessing how potential rate fluctuations could affect repayments.

Best and worst case scenarios

Mortgages are long-term commitments. You should consider how far your payments could increase in the worst case scenario and work out whether you could afford such hikes.

One of the key decisions in selecting your mortgage is whether to choose a variable or fixed-rate mortgage. At first glance, variable rate mortgages have lower rates and look cheaper. But with the likelihood of interest rates rising in the near future, there is no certainty that the cheap rate will last.

Variable rate mortgages

The size of repayment on a variable rate mortgage increases or decreases with the Bank of England base rate. Although mortgage rates tend to move in line with this base, there is no exact link between the two. Lenders decide if and when they pass on interest rate cuts or rises.

Tracker mortgages are variable rate mortgages but are linked directly to the base rate. For example, a tracker mortgage could offer the base rate plus 1%.

Mortgage rate scenarios

According to Moneysupermarket.com, the best three-year tracker, offered by Nationwide, is 4.99% for a first time buyer taking out a £100,000 mortgage with a £20,000 deposit.

At this rate, if the Bank of England base rate stayed at 0.5% over the next three years, you would pay monthly payments of £590.67 for this period.

If mortgage rates increase in line with the rates implied in the Bank of England report, your mortgage rate would increase by 1.6% within a year, at which point your mortgage payments would have increased to £688.87 per month.Within two years, your mortgage rate would increase by 3.2%, and you would be making payments of £773.33 per month.

By the end of your three-year tracker term, you would be paying £806.82 per month. At this point you would move on to the standard variable rate and pay even more.

Even if interest rates rise to these levels, they would still be relatively low compared to some periods in the past. In the early 1990s, the Bank of England base rate was nearly as high as 15%. If you were on the Nationwide tracker at these base rate levels, you would be paying £1,628.08 per month, which is more than three times the average three-year tracker today. This may be unlikely, but it has happened before.

It is worth bearing in mind that you may be able to remortgage again when the discount runs out and get another good deal, but if interest rates start to rise, it will be increasingly difficult to get cheap variable or fixed-rate deals. Furthermore, if you leave your mortgage early, you will have to pay an early redemption fee.

Ftbs have to ensure that they will be able to cover the increased costs if necessary.

If you think that you would be in trouble if rates rise above a certain point or don't want the uncertainty, perhaps a fixed-rate is for you.

Fixed-rate mortgages

With a fixed-rate mortgage, the interest charged remains the same throughout the term of the fix. Lenders typically charge higher interest rates for these mortgages because they guarantee the rate. The amount you pay is fixed for a set period of time, usually between two and five years. Historically, fixed-rate mortagages were more popular, but low interest rates have encouraged buyers to go for cheaper variable rate deals, and the prices of fixed-rate mortgages have fallen recently as a result.

Some commentators suggest the good deals on fixed-rates will not last long as buyers worry about interest rate hikes and demand for fixed deals increases. Some are encouraging buyers to go for fixed-rate mortgage deals now.

As Andrew Montlake says: "Many borrowers who should be fixing may well be leaving it dangerously late".

Fixed-rate scenario

According to Moneysupermarket.com, the best three-year fixed-rate mortgage, available from Lloyds, offers 5.09% for a £100,000 ftb mortgage with £20,000 deposit.

Monthly payments would be £596.61 for the entire three-year term. In comparison with the tracker scenario above, you would pay £4,148.40 less over the same three-year period.

Choose wisely

This shows the impact of one possible scenario, but there is a wide range of predictions to consider. Interest rates may stay low, rise steadily or spike - there are no cast-iron guarantees.

The key is to take out a mortgage that you can still afford to pay should interest rates and, consequently, repayments rise. The question you must ask is - can I afford the worst case scenario? If not, it may be worth focusing on fixed-rate options or even waiting until you are in a better position financially.

Considering all the options now ensures that when you do get on the ladder you'll have peace of mind and will be able to cope with potential rate and repayment fluctuations in the future.