The Bank of England’s Monetary Policy Committee (MPC) meets monthly to decide whether to raise or lower the base interest rate, which in turn affects mortgage rates and your monthly repayments. Over the last year, the MPC has been priming homeowners to be prepared for an interest rate rise.
The base rate is currently at 0.50%. It first reached this level in March 2009 after the Bank of England took the dramatic step of cutting rates six times in as many months to help combat the impact of 2008’s financial crisis. The base rate was at 5% just six months earlier in September 2008. It was further cut to 0.25% in 2016 before rising back to 0.50% in November 2017.
This means people who bought their home after March 2009 have never faced paying a “normal” interest rate on their mortgage, which has historically been between 5 and 15%.
So, how would you cope if interest rates were gradually increased to 2 or 3% over the next 18 months and how can you prepare your finances for this scenario?
What impact would a rate rise have?
Mortgage providers adjust rates on mortgage products when the Bank of England base rate changes. The impact of a rate rise depends on the amount you owe on your mortgage.
If your mortgage is £100,000 and base rate goes up by 0.50%, you’ll pay around £400 extra per year or £33 extra each month. The more you owe, the bigger the impact of a rise – if the increase in base rate was a full 1% on a £200,000 mortgage, you’d be paying around £1,600 more each year.
The impact also depends on what type of mortgage you have. If you have a fixed rate mortgage, changes in base rate won’t affect you until the end of the mortgage deal because the rate can’t change until then. This is why five-year fixed rate deals are popular when rates are expected to rise because you can lock into a rate for an agreed period.
However, if you’re on a variable or tracker rate mortgage, the interest rate is linked to the base rate – which means your mortgage provider will likely alter the interest rate on your mortgage in line with any changes to the base rate, and thus the size of your monthly repayments.
Tracker mortgages, as their name suggests, track the base rate, so a rise or fall in base rate will mean a rise or fall in the interest rate you pay.
If you are on your lender’s standard variable rate (SVR) – which normally happens after your special promotional or introductory period ends – you are likely already on an interest rate that is much higher than the best tracker, variable, or fixed rate mortgage products on the market. Irrespective of whether the base rate goes up or not, you should consider remortgaging to a more competitive deal.
Here are a few ways to prepare for an increase in the Bank of England base rate:
- Create a savings cushion
- Build more equity in your home
- Overpay your mortgage
Create a savings cushion
If possible, create a savings cushion to provide protection for unforeseen expenses, like a rise in your mortgage repayments. Ideally, we’d all put aside 5 to 10% of our income. Experts suggest having a cushion of three months’ salary, in case you lose your job or face big unexpected expenses like needing a new car.
With the various pressures on household finances, this is not easy or always possible. If you have to borrow or get into debt, try and do this in the most cost-effective way by borrowing cheaply.
Your ability to do so will depend on your credit rating, but aim to borrow interest-free for as long as possible and repay any credit card debt before the interest-free period ends.
If you have debts that charge interest, it’s usually a better idea to repay those debts than putting your money into a savings account – the interest on the debt will probably be more than the income you’d earn from the interest on your savings.
Build more equity in your home
The best way to prepare for an interest rate rise is to reduce your mortgage, increase equity in your property and lower the loan-to-value (LTV) ratio on your mortgage. The LTV ratio dictates what mortgage deals you’ll be accepted for.
So, when you first buy a property, you might put down a £10,000 deposit on a £200,000 home – a deposit of 5%.
This means your LTV is 95%. The quicker you can lower this figure, the lower the mortgage rates you can get accepted for and the cheaper your mortgage will be. The best deals are reserved for those with an LTV ratio of 60% or less, but there are still some good deals at 80% and 85% LTV as well.
Salary increases won’t automatically build more equity but will help you get accepted for better mortgage deals, which cushion the impact of an interest rate rise.
It varies from lender to lender, the value of the house, your credit score, and the size of your deposit, but usually you can borrow around four-and-a-half times your income (or joint income, if you’re applying for a mortgage with someone else). If you earn £50,000, you should be able to get a mortgage for £250,000, for example. A higher salary helps when you face higher costs, and makes it more likely you’ll be able to overpay on your mortgage.
As you pay off your mortgage on a repayment mortgage, you’ll gradually have more equity in your property and qualify for cheaper deals. You also gain greater equity if the price of your property goes up from the price you paid for it.
If you’re a home owner, the holy grail is to do whatever you can to reduce your LTV, because then you qualify for cheaper deals and save money on interest repayments.
The lower your outstanding mortgage value, the less impact any rise in interest rates will have.
Overpay your mortgage
Another strategy to increase equity in your home, lower your LTV ratio and protect against interest rate rises is to overpay your mortgage.
Aside from the benefits mentioned above, overpaying saves you lots of money overall in mortgage interest repayments because of how compound interest works.
Mortgage interest accrues on the full amount of your mortgage over its entire term, so by overpaying you reduce the principal balance which interest is charged on – so lowering it cuts the amount of interest you pay.
Normally you can overpay up to 10% of the outstanding loan each year. Be careful though because there are severe penalties for overpaying too much, especially on fixed-rate mortgages.
Here’s an example to illustrate the power of overpaying on your mortgage. The property cost £200,000 and you managed to put down a 25% deposit, £50,000. If you repay the £150,000 on a repayment basis over 25 years at an average interest rate of 4%, you’ll repay £237,428 overall – that’s £87,428 in interest.
If you overpay a bit each month, or perhaps a few lump sums when you can, and pay off the mortgage in 20 years rather than 25, you’ll repay a total of £218,078 – a saving of almost £20,000.
That’s just one example; your financial situation might be very different. If you own a house and you’re worried about interest rates going up, it’s a good idea to use a mortgage calculator and play with the numbers. When you see see how much money you can save in the long run – not to mention the reduced exposure if your interest rate increases – then you’ll fully appreciate the value of increasing your home equity.
Now read our in-depth guide on paying off your mortgage early