A Finance Daily member asks the experts what type of mortgage is best to cope with unpredictable interest rates.

Question

I am currently on my mortgage lender’s Standard Variable Rate (SVR) having just come off a good fixed rate with them for the last two years. With interest rates likely to rise, what mortgage type should I go for? Are interest rates likely to keep going up, or should I choose a tracker so I can benefit if they come down soon. I have also read some stuff about Off Set mortgages, but am not sure how they work? All advice welcome.

Jason Butler of Bloomsbury Financial Planning responds:

The economic indicators point to a higher likelihood of them rising rather than falling in the short term i.e. 12 months. However, beyond that timeframe what happens to interest rates is anyone’s guess. If we start to see property prices falling and growth and inflation falter over the next 18 months then the medium term outlook could actually be a reduction in interest rates. As a general rule of thumb one will pay slightly more than the average variable rate with a fixed rate mortgage. With a capped rate mortgage (where interest is variable but cannot rise above an upper limit) one will also generally pay slightly higher than a variable/tracker loan. A tracker loan will, as the name implies, usually track the Bank of England base rate plus a margin set at outset by the lender.

The decision on whether to take a fixed or variable rate (tracker or standard) will depend on both how well you can weather fluctuations in interest rates and what will help you to sleep well at night! If your loan interest represents a large proportion of your outgoings then a fix rate might give you greater budgeting certainty, even if you pay a bit more than a variable tracker mortgage over the same period. However, if the interest cost of the mortgage is a relatively small amount of your total outgoings/income, then you might be better served taking a tracker mortgage either with or without an offset facility.

With an offset mortgage the value of any savings you have are effectively deducted from the amount of your loan in order to determine how much interest you need to pay. Although you don’t physically receive any interest on your savings the effect is that you receive a return on your savings equal to the interest you have saved on the mortgage. For example, let’s say you have a £100,000 mortgage with a variable tracker interest rate of 6.00% (i.e. 0.75% over bank base rate) and you also have savings of £10,000. The £10,000 savings reduces the mortgage to £90,000 so instead of paying monthly interest of £500 you would only pay £450. The effective return you have received on your savings is therefore 6% net or 7.5% for a basic rate tax payer or 10% for a higher rate tax payer – risk free! You are free to withdraw your savings at any time, but the amount of mortgage on which interest is based will rise.

If the loan isn’t too much for you to service given your current income I’d suggest you go for a cheap tracker offset mortgage and over pay as much as you can possibly afford into the mortgage on an ongoing basis. That way you’ll create your own hedge against rising interest rates while giving yourself the maximum amount of flexibility in the future and you shouldn’t pay over the odds for the privilege.

Daniel Clayden at Clayden Associates Ltd responds:

If you think that interest rates are likely to go up then the best type of rate to take advantage of would probably be either a fixed or a capped rate (however this would obviously depend on the actual rate of interest being offered!), the main difference being that while fixed rates are fixed and do not change during the fixed rate period, a capped rate can come if interest rates fall but wont go above a certain specified rate – the cap (however the range of capped offers available a generally very limited and they normally come with a collar – which means that even if rates do come down the rate will only fall to a specified rate). Other factors that should always be considered when choosing a mortgage rate are the arrangement fees (including valuation, booking and legal fees), both standard and early redemption penalties (including any penalty period which extends past the fixed rate – typically known as ‘overhang’), the ability to make overpayments without penalty (many lenders now offer the facility to repay up to 10% of the outstanding mortgage balance in any year without penalty – even during the fixed rate period), and what happens to your rate at the end of the current deal.

If you want to know whether rates are likely to continue rising then I think you’re probably better asking Gordon Brown (Chancellor and next Prime Minister?) or Mervyn King (Governor of the Bank of England) … no but really it is impossible to say with any certainty, however my own opinion is that I believe interest rates will probably go up and then come down again over the next couple of years. There seems to be no real economic reason for rates to increase dramatically at the moment other than to try and cool down the housing market – as inflation is still at a fairly historically low level and the UK economy seems to be bubbling along quite nicely … but I haven’t got a crystal ball!

Obviously if you think rates may come down again then a variable or tracker rate may well be more cost effective over the mortgage term. Before you make any decision you should consider the risks – for fixed rates you may be fixed at a higher rate and pay over the odds if future rates fall and for variable rates if interest rates rise then so do your monthly payments. Generally if your monthly mortgage payments take up a large proportion of your monthly income then you really should think about fixed rates (consider the potential impacts of future interest rate increases … will you be able to afford to pay your mortgage if rates rise by say 1%?). Offset mortgages are a type of flexible mortgage where you offset any savings you have against the balance of your mortgage, only paying interest on the overall balance.

This can have the effect of making overpayments on the loan and therefore helping to repay the loan quicker, however for these types of mortgage to be really effective you need have a reasonable amount of savings to offset against the mortgage (also you need to take into consideration the fact that you wont get interest on your savings if they are being offset against your mortgage).

I would recommend that you seek advice from an independent mortgage adviser who can offer a recommendation specific to your needs.

Warren Perry, Head of Research, Churchill Investments Plc responds:

This is a topical question because as I write, many lenders have removed their fixed rate offerings from the market, a sure sign that interest rates are likely to rise soon. The key here is how much they are likely to rise by and how many more times are they likely to rise. If your view is that rates are likely to rise to levels higher than people expect and to stay at high levels, then a fixed rate mortgage may make sense. However, I think that the consensus view is that rates may rise a couple of times from here but that they should start falling again later this year. On that basis, a tracker would make more sense. It is a case of shopping around and deciding what is the best and most practicable/affordable deal for yourself.

An offset mortgage works on the basis that you have a series of accounts with one provider. The interest received on the current and savings accounts is offset against any interest due on the mortgage. You then pay the difference. Intelligent Finance has an excellent demonstration and calculator on their website.

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