FOOL'S EYE VIEW
Manage Your Mortgage

By James Carlisle
March 8, 2002

It's been a good couple of years for homeowners. Prices have been on the increase and the cost of mortgages has been falling, as the Bank of England has cut base interest rates by a third, from 6% to 4%, in an attempt to stave off the worst of a global downturn.

Yesterday, base rates were held at the 4% mark, but the consensus of opinion is that we're now close to the bottom of this particular cycle. So what's the outlook for interest rates now and what can homeowners do about it?

Interest Rate Outlook

Despite what the 'experts' might tell you, forecasting interest rates is easy if you accept your limitations. Sure, everyone will have their own opinion, but the beauty is that those opinions are condensed into the market for government bonds (or 'gilts'). So, by looking at the interest rate (or 'yield') that the market considers appropriate for a gilt that matures in, say, three years' time, you get the market's best guess about what interest rates will do between now and then.

The Bloomberg website has a handy table for doing just this. (The table changes over time, so I've reproduced part of it here so we're looking at the same figures.)

Time             Yield
Period               %

Three months      3.95
One year          4.91
Three years       5.01
Five years        5.26
Ten years         5.23
Twenty years      5.12

There was an article back in November 1999 that goes into more detail about all of this (you can find it here) and it gives an idea as to how reliable the types of estimates are. The base rate back then was 5.5% and the market was expecting it to increase to 6% by about now, to restrain the booming economy. So it failed to spot the downturn coming, but then it was far from being the only one (by definition, in fact).

So the gilt market is a handy guide to interest rates, but it's far from perfect. An economic recovery could be sooner and stronger than anticipated and that could send interest rates far higher than expected, perhaps up to 8% or more if inflation reared its ugly head. That would be double the current level and could cause trouble for some homeowners. If you're worried about interest rates rising, and you should be at least a little if you have a mortgage, then there are several things you can do about it.

Reduce your mortgage

One option, if you're lucky enough to have the money lying around, is to reduce your mortgage. The trouble is that if you do have the money lying around, it's probably there for emergencies and a sudden surge in interest rates is just that sort of emergency. So, if you use your cash to pay off a small part of your mortgage, it then won't be there to help you through the higher mortgage payments if and when they arrive.

One way to deal with this would be to use a 'flexible' or 'current account mortgage'. With these, you can use excess cash to pay off some of the mortgage, making your payments lower, but the cash will still be available to you, up to a pre-set limit, should you need it. That way, you can pretty much have your cake and eat it.

Fix your rate

What you're aiming to avoid is the situation where interest rates take a sudden hike and leave you struggling to make the payments. It matters less if they rise gradually since it will most likely be accompanied by inflation, which should also lift your pay packet over time. So you can get yourself some short-term certainty by fixing your interest rate for several years from now.

The rate at which you can fix your mortgage relates to the gilt yields we looked at earlier, although the mortgage rate will tend to be about 0.75% to 1% higher than for the lender to make a profit. For five years, the gilt yield is about 5.26%, so you'd be looking at fixing your mortgage for five years at around the 6% mark. You'd be paying more than a variable rate mortgage would cost now, but it should even out over the five years as interest rates rise. If they rise less than expected, you'll lose out, but if they rise more than expected, you'll gain.

What fixing does is provide you with some certainty. As the five-year mark draws near, you might need to fix at a higher rate, but you'll at least see it coming and, if it's a result of higher inflation, you should also be getting a higher pay packet. If you really want to make sure of that, then you could consider fixing the interest rate for ten years, but then that would be a long time to regret the decision if interest rates fell more than expected.

Cap your rate

If you want to protect yourself against an interest rate surge, but don't want to end up looking like a prize Charlie if rates plummet, then you could think about an interest rate 'cap'. These basically mean that your mortgage rate can't rise above a certain level, but it will fall if interest rates drop.

So, a capped rate mortgage means you can win if interest rates fall, but you can't lose if interest rates rise. It sounds too good to be true and it is. Somehow, your lender needs to be paid for the fact that things are weighted in your favour. That means that the overall mortgage rate will tend to be slightly higher than average. So, if you were able to get a five-year fixed rate mortgage at 6% (about 0.75% above the five-year gilt yield), you might be able to get a deal where the interest rate was capped at 6.25%, but which stayed a full 1% above base rates if that's lower.

You can probably already see the problem with capped rate mortgages: they lack transparency, they're hard to compare and it's therefore hard to know if you're getting a good deal. Still, if you shop around you should get an idea of what's available and you might find the balance you're looking for.

Stay within yourself

The simplest solutions are often the best, and the easiest way to make sure your mortgage doesn't turn into a nightmare is to stay well within yourself. When you start out with a mortgage, you should think to yourself, could I manage if my mortgage payments doubled? It may not be comfortable, but you should be able to manage for several years at that level. Eventually, the inflation that most likely caused the high interest rates should feed through to your pay packet and it'll become more manageable. But you should be prepared to sit through a nasty spell. Property is a long-term investment and you need to make sure you can stay the course.

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