Where do we start when looking at fixed or variable rate mortgages? Well, since the US subprime mortgage market crisis, which began in 2007, UK base rates have been at near record lows until recently. It is safe to say that many people took advantage of historically cheap mortgages to acquire their dream homes. We also saw many homeowners looking to remortgage their property at very low rates. The Bank of England indicated base rates would rise to combat inflation. However, nobody expected the sudden increase seen over the last few months.
The current uncertainty has seen many people researching whether fixed or variable mortgage deals suit their situation best. There are numerous factors to consider for different situations. While there is no definitive answer, it is vital to be aware of the options.
Different types of fixed or variable mortgages
Whether looking at a fixed or variable mortgage, there are several options to consider. As this is a very competitive marketplace, it is essential to shop around. We will now take a look at the specific type of fixed and variable mortgages available.
Fixed-rate mortgages
The fixed-rate mortgage market is relatively straightforward; with first-time buyers typically offered attractive rates to entice new customers. There is also a very active remortgage market offering existing homebuyers the chance to fix their rate for an agreed term. The duration on these types of mortgages tends to be fixed for:-
- One year
- Two years
- Three years
- Five years
Interestingly, Virgin Money recently launched a 15-year fixed-rate mortgage in an attempt to replicate the US market. It is commonplace for US homeowners to fix the rate on their mortgage for the entire duration of the arrangement. In some cases, this can be 30 or even 40 years, offering a valuable degree of stability when organising your long-term finances.
Whether this will ever catch on in the UK remains to be seen, with traditional mortgage providers reluctant to go over a five-year fixed-rate period.
Variable rate mortgages
When you start researching the suitability of fixed or variable mortgage arrangements, you will notice many different variable rate mortgages on offer. As the term suggests, the rate on this particular type of mortgage is not fixed. Typically, it will be the mortgage provider’s standard variable rate (SVR), but several variations exist. These include:-
- Capped variable rate mortgage
- Discounted variable rate mortgage
- Tracker rate mortgage
When you start to dig a little deeper, you will see that there are more variations of variable rate compared to fixed-rate mortgages.
How big is the UK mortgage market?
It is important to put the size of the UK mortgage market into perspective. As of July 2022, the UK had £1.6 trillion in secured mortgages. This equates to around £58,000 in mortgage funding per household. According to the UK Finance website, at the end of 2021, 74% of homeowner mortgages were fixed-rate. Interestingly, since 2019, 96% of new mortgage borrowers have chosen to fix their interest rate.
Source: https://www.ukfinance.org.uk/news-and-insight/blogs/how-the-bank-rate-affects-mortgage-rates
When considering a fixed or variable mortgage arrangement, it is no surprise that fixed-rate mortgages have recently been extremely popular. Many of those looking to remortgage, downsize, or upsize, as well as first-time buyers, were keen to lock into historically low mortgage rates. But, as we know, the situation has changed recently, with UK base rates now standing at 3% after a recent 0.75% increase. The next meetings are due in 15th December 2022 and 2nd February 2023.
The most recent change was the largest one-off increase in interest rates since 1989, with the Bank of England suggesting the UK is facing a two-year recession. So if you are looking to secure mortgage finance today, the decision between a fixed or variable mortgage may be more challenging than in recent times. We will now look at the outlook for UK interest rates in the short, medium and long term and how this may impact the type of mortgage you look to secure.
Outlook for UK interest rates
As the Bank of England chart below shows, until recently, UK rates had been at or near their historic low. This trend emerged some time ago, in light of the 2007 US subprime mortgage crisis which prompted financial contagion and a worldwide recession. Unfortunately, inflationary pressures also emerged towards the end of 2021. This saw the Bank of England start to move interest rates higher. The situation recently worsened with the UK now on the verge of a recession. Base rates forecast to hit 5% and inflation still in double digits. Furthermore, while the pandemic caused supply chain issues, leading to inflationary pressure, the energy crisis has added to inflation and is very difficult to resolve.
UK Interest Rates
Source: https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp
The initial gradual uplift in base rates during 2022 increased dramatically towards the end of the year due to the worsening economic crisis. We then had the Conservative government meltdown, caused by an unfunded budget, which prompted a significant increase in borrowing rates. However, yet another change in Prime Minister and the third Chancellor of the Exchequer in less than a year has seen a degree of stability return to markets.
It is essential to put this into context regarding interest and mortgage rates. For example, before the disastrous mini-budget announced in September, two-year fixed-rate mortgages were available at 4.74%. However, the rate peaked at 6.65% on 20 October and now stands at around 6.46%. The situation with five-year fixed-rate mortgages is similar. Rates were around 4.75% before the mini-budget, reaching a peak of 6.51% and now standing around 6.3%. These numbers are correct at the time of writing this article and are subject to change.
After the recent 0.75% increase in base rates, the Bank of England specifically commented on market expectations in the short and medium-term. Before the recent rise, analysts were expecting UK base rates to peak at 5% by the end of 2023. The Bank of England has recommended analyst review their expectations, suggesting they were too high, but no specific figure has been mentioned. While it won’t be anywhere near the 3% expectations just six months ago, rates are now expected to peak at under 5%.
This recent shift in expectations will impact those currently considering a fixed or variable rate mortgage.
Fixed or variable rate mortgages: The pros and cons
After comments by the Bank of England, many leading mortgage providers in the UK expect to see fixed rates soften over the coming days and weeks. However, several issues still need addressing before the UK is back on a stable economic footing. This prompts the question, what is the best option for first time buyers or those looking to remortgage, fixed or variable rate mortgages?
Pros of fixed-rate mortgages
The main benefit of a fixed-rate mortgage is the fact that homeowners can plan ahead in relation to their finances. As their rate is fixed for one, two, three or five years, they know how much they require for their monthly mortgage payments. This type of mortgage is also useful if rates are expected to rise in the short to medium term.
For example, when UK base rates were hovering just above 0%, it was possible to lock in a fixed-rate mortgage at circa 2%. Compare this to 4.7% in September and 6.4% more recently. The benefits of locking in a fixed rate are there for all to see!
Cons of fixed-rate mortgages
There are two specific challenges when it comes to fixed-rate mortgages. Firstly, it is very easy to get used to a relatively low rate, as we have seen in recent times. However, looking at the figures above, the current rate has more than trebled. Consequently, those coming to the end of existing fixed-rate mortgages will again have a dilemma. Do they look towards fixed or variable mortgage deals? Unfortunately, both options will be based on significantly higher monthly mortgage payments.
If the graph below, showing the forecast path of UK base rates in the short to medium-term, is correct, then rates will peak at around 4.8% in 2023, falling back to 3.5% in 2027. Consequently, two-year and five-year fixed rates could soon be significantly less than today’s rate. However, today’s figures also reflect some uncertainty, which markets do not like, that can result in a risk premium.
Source: https://moneytothemasses.com/owning-a-home/mortgages/should-you-fix-your-mortgage-now
The Bank of England forecasts that around 40% of outstanding fixed-rate mortgages will be up for renewal in 2022/2023. Faced with a dilemma, thousands of mortgage holders have much to think about. Should they choose a fixed or variable mortgage deal?
Pros of variable rate mortgages
While variable-rate mortgages create a degree of uncertainty for the holder, they can be beneficial in certain circumstances. For example, if you believe that UK base rates were set to fall significantly in the short to medium term, it could be detrimental to your finances to take out a fixed-rate mortgage. However, if you went for an SVR, the interest paid on your mortgage debt would fall broadly in line with base rates.
Looking back at the end of 2007, when the US mortgage crisis began, UK base rates were circa 5.5%. While these were extraordinary times and uncharted waters, if you had chosen a variable mortgage, your mortgage rate would have fallen from more than 6% down to around 2%. Conversely, if you had fixed your mortgage rate at more than 6%, then you would have been locked in for potentially five years. During this time, base rates collapsed, and mortgage rates stabilised at around 2%.
Cons of variable rate mortgages
Whether base rates rise or fall, homeowners using variable rate mortgage finance will always have an element of uncertainty about future mortgage payments. As we touched on above, this move may prove highly beneficial, but then again, it may not work out. This can make it very difficult to plan ahead and budget mortgage payments out of your household income.
The main danger with variable rate mortgages is that interest rates rise suddenly and you see a significant increase in mortgage payments. While unexpected, this is the scenario many homeowners are facing today. Variable mortgage rates have increased dramatically from around 2% to more than 6%, In some cases, they are approaching 7%. The speed at which mortgage rates have moved in the UK, because of base rate increases, is extremely rare. However, while magnifying the challenges for those looking towards a variable rate mortgage, it does highlight the dangers.
Changes in fixed or variable mortgage payments
Martin Lewis recently suggested that every 1% increase in your mortgage rate equates to an extra £50 a month or £600 a year on a £100,000 mortgage. If base rates jump from 3% to around 4.8% in the next 12 months, mortgage payments will rise signficantly. For example, variable rate payments on a £100,000 mortgage will rise by over £1000 a year. The fact that some publications are referencing average two-year fixed mortgage rates of 6.47% and five-year rates of 6.32% suggests we may be nearing the peak. Ten-year fixed-rate mortgages, currently standing at 5.65%, further support this argument.
Example of fixed or variable mortgage
We will now compare and contrast a standard variable rate mortgage with two-year and five-year fixed-rate deals. The figures in the table are based on a 25 year repayment mortgage of £100,000. We have assumed interest rates will peak towards end of 2023 and then gradually coming down. We appreciate that the SVR will vary constantly over the year, but for illustration purposes we have used a fixed rate at the start of the year. Using the current Barclays SVR of 6.74%, the rate is currently 3.74% above the base rate. We will maintain this in our calculations.
The above figures are just for illustration purposes. However, you can see that the variable-rate mortgage payments totalled £43,344 over the five year period. The two-year fixed rate, which then switched to an SVR after year two, led to repayments of £41,544. The five year fixed rate is the best option in this instance. This deal saw total payments of just £39,840 over the five year period.
It is impossible to say with absolute confidence where UK base rates will be in two, five or ten years. The increase in base rates over the last few months will help to control inflation. However, the UK economy could still tip into recession. Alternatively, once energy costs are under control, we could see interest rates fall relatively quickly to help support the economy.
If inflation continues to eat away at the economic prosperity of the UK, rates may have to rise even further. Consequently, it is difficult to say with absolute certainty whether it is best to look at a short-term fixed rate. Or should you leave yourself at the beck and call of the market with an SVR. Tracker rates with discounted 2-year variable rates can throw a spanner in the works with variable rates being offered at 0.8-1.5% above the base rate. These usually come with a premium at the beginning (i.e. £990 arrangement fee).
Conclusion – fixed or variable mortgage?
While the basic pros and cons of fixed or variable mortgage rates remain, we are in a relatively unique situation at the moment. Even though UK interest rates are expected to peak over the next 12 months, there is no guarantee they will come down sharply. While the two-year fixed rate compared to the 10-year fixed rate suggests interest rates are likely to fall, ten years is a long way away!
In many ways, the situation we are in today highlights the benefits of quality mortgage advisers. They will be able to walk you through different scenarios. Explaining the variables, potential costs and changes in your mortgage payments. For example, if inflation comes down quicker than expected, base rates will follow suit, as will mortgage rates. In this case, a variable or tracker mortgage will be the best. However, if inflation remains stubborn and energy costs remain high, then the Bank of England may need to increase base rates to a higher level than current expectations. Then, a fixed rate becomes the cheapest. All very complicated!
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