Securing a low interest rate is crucial when purchasing a home to ensure manageable monthly mortgage payments. Understand the influencing factors with Moneysprite advisers.
How do Mortgage Interest Rates Work?
What determines mortgage interest rates?
Have you ever wondered why mortgage interest rates change and what makes them change? Well, there isn’t one specific factor that causes interest rates to change. It’s a cocktail of different events and circumstances that influence these rates, meaning it’s not always clear or straightforward. However, we’ll make sense of it all here without confusing jargon.
Once you’ve grasped this key information, we recommend taking a look at our new article on early mortgage repayment.
Economic indicators
The UK’s and even worldwide economic performance can influence mortgage interest rates. To understand how this works, we first need to take a basic crash course in one of the most valuable measurements of economic performance - inflation.
Inflation refers to the increases in the costs of goods and services over time. For example, a loaf of supermarket bread may have cost around 80p a decade ago but now costs £1.25.
When will interest rates go up?
Cost increases can result from events within or outside the UK, such as Russia’s invasion of Ukraine which caused supply chain issues. Inflation isn’t bad if prices rise steadily and wages keep up. The Bank of England has an inflation target of 2%, meaning the optimum level of price increases is 2%.
Inflation can rise quicker than the 2% target if people start spending more money rather than saving it. People usually spend more when they have more money but also, when prices increase because of reduced market competition. When there is less competition amongst businesses, consumers have fewer options and are forced to pay more.
When will mortgage interest rates go down?
The Bank of England can take steps to reduce inflation closer to the 2% target during these times. The primary step is the interest rate, and they may have to do this multiple times over a long period, such as in 2023. So, how does this help?
As the central bank, it lends money to high street banks but charges those banks interest on their borrowing. The interest charged to the banks is reflective of the base rate of interest. However, the banks adjust their mortgage interest rates based on the base rate charged to them by the central bank. In other words, the banks pass on any rate increases to consumers taking out loans. In theory, this should make people less inclined to spend or borrow money due to higher interest rates. It should simultaneously encourage people to save more of their money in a higher-interest savings account. When spending decreases, businesses then need to fight harder to win clients and customers, which should then increase competition and bring down prices.
Credit scores, loan terms and down payments
Some things that influence mortgage interest rates are personal rather than worldwide or national events, such as your credit score and the specifics of the mortgage you need. Your credit report records how you have managed personal finances over the last six years, which is then evaluated in a credit score. It considers all aspects of personal finances, including debt repayments. Mortgage lenders check your credit score as part of your application. If they notice you have a below-average or poor credit score, you may be offered a higher mortgage interest rate – and vice versa. This is because a poor credit score suggests to lenders that there is a greater risk you will default on the mortgage, so the lender offsets this risk to an extent by increasing the interest rate.
Mortgages are usually offered for 25 or 30 years. You may find some products that offer slightly shorter or slightly longer repayment periods. The general rule is that the longer the repayment period, the more likely that the interest rate will be higher. This is because the home buyer will be spreading repayments out for a longer period, which means it will take longer for the lender to be repaid.
Last but not least, from a personal determination on mortgage rates is your down payment. Most lenders provide a mortgage up to a maximum of 80% of the property value, meaning the buyer has to put down a 20% deposit. Of course, there are some exceptions and schemes that allow you to buy property with just a 5% deposit. The amount the lender provides is also called a Loan-to-value (LTV) Ratio, so a 20% down payment would mean a mortgage with an LTV of 80%. The smaller the LTV required, the less risk the lender takes, considering the potential for the property to decline in value. In other words, the bigger the down payment you can provide, the less of a risk you are in the eyes of lenders and the greater the potential to get a lower interest rate.
UK housing market conditions
Another factor affecting interest rates is housing market conditions, which is tied to the previous discussion on the Bank of England base rate. If more people want to buy a property than the number of properties on the market, there is a negative balance between supply and demand.
In these situations, the increased competition to buy property causes the price of property to increase, often through bidding wars. When this happens, it contributes to increasing inflation levels and the Bank of England may need to take action to reduce inflation and cool the housing market. As discussed, the central bank does this by increasing the base rate, which then increases mortgage rates. When mortgage rates increase, borrowing power decreases as lenders are willing to lend less due to increased interest repayments. When people can’t afford as much through a mortgage, they are forced to place lower offers on property, and thus, the housing market cools down.
Are all mortgages affected by interest rate changes equally?
There are various types of mortgages which can be put into two main categories, namely fixed-rate mortgages and variable-rate mortgages. A fixed-rate mortgage is sheltered against real-time changes that could change the interest rate. This is because, as the name suggests, interest rates are fixed for a set period in fixed-rate mortgages. No matter what happens to the economy and housing market, the lender cannot increase or decrease the interest rate during the fixed period. However, once the fixed period ends, the product will automatically switch to a variable product unless another fixed mortgage is agreed upon.
On the other hand, variable-rate mortgages are subject to ongoing interest rate changes based on the aforementioned factors that could change rates. This means the lender can increase or decrease the interest rate in response to the economy, the Bank of England and the housing market. The different types of variable rate mortgages, such as standard variable rate mortgages or tracker mortgages, may be affected by individual factors to varying extents. This is best discussed with a qualified mortgage adviser.
Utilising knowledge to get better rates
Understanding what affects interest rates is key to reducing the interest you pay to mortgage lenders over the loan's lifetime. It’s not just about finding the lowest rates available to you, but it’s about continually monitoring what’s available and predicting what may happen in the immediate future. For example, one question that always gets asked is whether you should lock in on a fixed-rate deal or stay on a variable-rate mortgage during periods of inflation.
Naturally, nobody can guarantee what will happen in the future and offer 100% guarantees on mortgage rate forecasts. Yet, professional mortgage advisers can utilise economic data and expert predictions to make informed recommendations to clients based on the information available. Additionally, it’s important to remember that choosing a mortgage also requires individual assessment with tailored advice.
Discuss mortgage rates with an expert mortgage adviser
Speak to one of our professional mortgage advisers for a personalised assessment of your situation and the options available to you. We work hard to uncover the most cost-effective mortgage deals while also considering all your long-term financial objectives. For a holistic and comprehensive mortgage advice service, look no further than our approachable team.
If you need help with your mortgage, call us today: 0345 450 4660
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