Interest rates have been at their lowest ever level now for half a decade. A deliberate economic policy designed to encourage people to spend and banks to lend, it means two simple things: good news for borrowers, and bad news for savers.
This may be about to change. The past few months have seen increasingly strong and frequent hints from the Bank of England that interest rates will soon begin to rise once again, and many homeowners and prospective buyers in the UK are concerned about when (and by how much) their cost of borrowing will increase.
Who is responsible for setting interest rates?
By and large, banks and other lenders set the interest rates for their own products, but these rates will be based upon the central rate set by the Bank of England.
Known as the Bank of England Base Rate (BBR), this benchmark rate is set by the Governor of the Bank of England and a committee of Bank of England policymakers.
Based on comments from the Bank of England over the past year, predictions as to when the Base Rate may eventually rise have varied. Following a speech on 11 June, markets briefly braced for a rise as early as autumn this year – before a seeming backpedal caused markets to revise their predictions once again.
The knowledge that any eventual increase in the base rate will be gradual and incremental should bring comfort to UK borrowers, but there could be an unpleasant side-effect to the mixed signals the Bank of England is giving. Faced with uncertainty as to the path of benchmark rates, lenders could begin to increase the ‘spread’ between the base rate and the rates they themselves charge 1. Simply put, mortgage costs could begin to rise prematurely.
The Office for Budget Responsibility (OBR) predicts that if interest rates were to rise by just 2.5%, nearly a quarter of the UK’s 11 million mortgage holders would be forced to “significantly” change their spending behaviour 2.
‘Cooling’ the housing market
Setting interest rates is not the only power the Bank of England has over the mortgage market. Very recently, it was given powers to intervene if it felt that house prices were rising too quickly.
On 26 June, the Bank exercised these powers, recommending that lenders place limits on the amount of high-value lending they do. From 1 October 2014, no more than 15% of new loans issued by a mortgage lender should be worth more than 4.5 times the borrower’s income.
The cap should have the biggest impact in London, where nearly a fifth (19%) of loans are at a loan-to-income ratio of 4.5 or higher 3.
What this means for buyers and homeowners
First-time-buyers in London are likely to feel the effect of these measures the most. According to the most recent data, the median income in London is £30,480 4, making the maximum capped amount that a single applicant could borrow £137,160. This could fund the majority of a one-bed flat in one of London’s cheapest boroughs (such as Enfield, Surbiton or Chingfield), but buyers hoping for a starter flat in most areas will need a sizeable deposit 5.
Broadly speaking, the Bank of England’s governor hopes that the measures will help to calm the housing market without affecting the rest of the economy. In theory, this will enable the Bank to hold fire on increasing interest rates until the economy as a whole can withstand it.
Current and aspiring mortgage holders might be worried that their borrowing costs might start rising sooner, and may even be tempted to switch their mortgage early, even if it means incurring early redemption penalties.
As the future of interest rates is an unknown, it is impossible to say whether this course of action would be the most cost-effective; however, the most important thing is not to panic. If you have any concerns about the mortgage you are on, call your lender or mortgage adviser to discuss them.
 www.londonpropertywatch.co.uk/avg_prices.html (as at 26 June 2014)