Interest Rate Changes and Risk

Why can banks increase interest rates on mortgage repayments, even though the Bank of England Base rate remains the same?

This is a good question from a reader.

Recently British and American mortgage lenders have been increasing the cost of their mortgages even though the Base interest rate has not changed. This is the explanation:

• The Bank of England (Fed in US) set the Base interest Rate. This is the most important interest rate in the economy. Most banks have to borrow money at this interest rate, therefore, it is very significant in determining other interest rates. If the Bank of England increase interest rates, the main banks will usually respond by increasing their standard mortgage interest rates by the same amount.
• This is what the Fed and Bank of England want. They want to influence the main interest rates in the economy

• However, the Bank of England are not able to directly set the different interest rates of a bank. The bank has independence to set rates according to how much profit it wants to make. For example, some banks may set their base mortgage rate 1% above the Bank of England base rate. Other banks may set it 2% above.
• When deciding on the interest rate to charge an important factor is risk. If a loan is risky a financial institution will set a higher interest rate to compensate for the increased risk of loan default. E.g. an unsecured personal loan to someone with bad credit may be 8.7%. A mortgage loan is secured against the value of the house - it is safer so rate may be only 5.4%
• If House prices are falling and the economy may be going into recession (like America) the bank feel mortgage lending is becoming more risky. Therefore, they may increase the interest rate because they now feel mortgages are a riskier loan.
• Banks are likely to increase the interest rate on riskier types of mortgages the most. For example, self certification mortgages, interest only mortgages and buy to let mortgages may attract an increase in the cost.

Conclusion

• Banks can increase the cost of mortgage products, if they think the mortgage lending market is becoming more volatile.
• Banks can’t change existing mortgage contracts.
• Interest rates set by banks are heavily influenced by the Central Bank, but, there are other factors at work as well.

Interest Rate Predictions UK