Understanding interest rates
Posted on 6th July 2023 at 15:33
It seems we cannot move for news about interest rates, and most of the news is negative with it all being doom and gloom. If we had a £ for every time somebody asked us what we think about interest rates, we wouldn’t need to advise at all! But it’s a hot topic of conversation at the moment so its only right that we discuss that here now and explain how interest rates are decided and why some lenders can offer different rates to other lenders.
Most of the money lent out by lenders comes from the UK's central bank – The Bank of England. The bank of England’s main role (apart from printing and issuing the money in circulation) is to control the rate of inflation. The Bank of England issue majority of the money lent out so when they change the rate in which lenders get their money, that alters the rate in which customers borrow their money.
When lenders and banks borrow money from the Bank of England, they will borrow it at the base rate (as of today this is 5%) so lenders borrow their money at 5%, add their profit margin and lend that money to you at a slightly higher rate. So, depending on what rate the Bank of England decide on, that will determine what rate you get your mortgage at. If rates go up, your rate will go up.
Although this makes up most of the lending, some lenders have their own sources of money that they can lend out. Building societies for example use customers savings and current account funds to lend out as mortgages. Building societies such as Nationwide and Halifax who have 100,000s of customers depositing money into their accounts have £1,000,000s they can lend out at lower rates than the bank of England because they get this money cheaply from their members in the form of low interest savings accounts or ISAs.
If building societies keep the interest rate low on savings accounts, they have cheap money they can then lend out for mortgages at a higher rate than the savings account rates, but slightly lower than some lenders who are dependent on the bank of England, so they become a more attractive option and keep their share of the ‘mortgage market pie’.
The level of business lenders currently has will also determine what rates they can offer new customers too. Just like any other market type, if a seller wants more business, they will have a ‘sale’ where they sell their products cheaper than their competitors or cheaper than normal to encourage more buyers to buy from them. Lenders are no different, if they have capacity to take on more customers, they will reduce rates to stand above other lenders and acquire more business. Once they have filled their quota or they can no longer lend money out at that rate anymore because they have lent out all of that cheap money, they will increase their rates until another lender becomes the cheaper option, and all brokers use that lender instead.
Some lenders will continue a cycle like this until they hit their quote, clear their decks and repeat. Some of the larger lenders who have a larger capacity to lend won’t be as flippant as this and can maintain a steadier level of interest rate over a period of time rather than fluctuate as and when they need more business.
Swap rates are simply when two parties swap interest rate payments for another. Where one party
agrees to receive a fixed-rate payment, while the other receives a variable payment. In the case of
mortgages, it is what lenders pay to financial institutions to acquire fixed funding for a set period of time. They can be on a number of fixed terms (1, 2, 5 or 10 years) and the cost set out by the initial fluctuate is used to price mortgage product for lenders. As swap rates are based on market stability, if they rise then mortgage lenders will likely increase their pricing to maintain their profit margin, or if they rise too rapidly then they may have to pause lending or withdraw products until pricing stabilizes.
Variable rate mortgages are relatively simple to grasp as they are causational, as the base rate increases so does the lenders standard variable rate and subsequently all the other variable rates. However fixed rate mortgage deals are different as they are priced according to the swap rate market and not intrinsically linked to the wider money markets. As swap rates are priced on market power/market certainty, unfortunately, given what’s happened in the last few years and months (COVID, war in Ukraine, an ever changing political landscape and so on) at the minute swap rates are increasing which naturally leads you to believe that mortgage lenders fixed rate products will do the same. In the short term, we believe that fixed rate mortgage rates are going to increase – not decrease. If we are right, then whatever rate you can secure today might just be the best mortgage rate you’ll be able to access for a while. Even if you think you’ll only need to apply for a mortgage in six months’ time, the rate your lender agrees today is locked in for six months.
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