Mortgage Interest Rates Explained

Mortgages are paid back over a period of 25-50 years. Monthly mortgage repayments depend upon the interest rate charged by the bank building society. Homeowners choose between variable interest rates and fixed interest rate mortgages.

Variable mortgage interest rates.

Most mortgages in the UK have a variable mortgage interest rate. This means that the interest rate on the mortgage depend on the base rate, set by the MPC. If the base rate increases by 0.5% the rate charged on your mortgage will increase by a similar rate.

Therefore, every month, many homeowners anxiously await news from the Bank of England when they decide on the base rate.

How Does Bank of England Set Interest Rates?

The Bank of England is actually not primarily concerned with the housing market and homeowners. The government has given the Bank just one objective - an inflation target of CPI = 2% +/-1 Therefore, the Bank of England will seek to keep inflation within this rate, even if it means hardship for mortgage owners.

When setting interest rates the Bank of England are trying to predict future inflationary pressures. If inflation is forecast to rise, the Bank of England will be forced to increase interest rates. Higher interest rates help to reduce inflation for the following reasons.

• Increases cost of borrowing therefore discourages people from consuming and investing.
• People with borrowings (especially with mortgages) will have less disposable income, therefore consumer spending will fall.
• Increases incentive to save rather than spend.
• Increases value of pound making exports less competitive.

For all the above reasons higher interest rates reduce domestic demand, slow down growth and therefore lead to lower rates of inflation.

However, monetary policy does have some limitations.

• Not everyone is affected equally by higher interest rates. e.g. young first time buyers will be heavily hit by a rise in interest rates. Older people with no mortgages and significant savings will actually be better off (more income from savings) Therefore, to reduce inflationary pressure it may be necessary to have higher interest rates which cause hardship for those with mortgages.
• Time Lags. The effect of interest rates doesn’t happen at once. It can take up to 18 months to have an effect.

Fixed Interest Rate Mortgages.

Fixed interest rate mortgages, by contrast are set for a certain time frame, like 2 years, 5 years or 10 years. They offer security and peace of mind; they also make it easier to budget. People prefer variable mortgages, perhaps because people hope interest rates will fall! However, amongst first time buyers fixed rate mortgages are becoming increasingly popular. This is perhaps because many first time buyers couldn’t afford to pay higher rates if the bank increased base rates