The only interest in yesterday’s Bank of England meeting was whether or not it would result in a statement reducing the unemployment target but with the next Quarterly Inflation Report due in February there must be a good prospect that if the MPC plans to change its “Explicit Guidance,“ as indicated particularly by comments from MPC member Charles Bean even before unemployment had fallen to 7.4%, this will happen next month, especially if the next set of unemployment figures pushes the rate down further.
International considerations as well as UK specific economic factors will of course be relevant in any adjustment of the MPC’s targets and the timing of the first increase in Bank Rate. In this context it is interesting to compare the recent performance of the UK’s gilt market with a country very close to home. On Tuesday of this week Ireland’s issue of 10 year bonds was 3 times oversubscribed and it sold Euro3.75bn of bonds on a yield of 3.54%, only 59 basis points higher than the closing UK gilt yield that day.
Following the success of this issue yesterday’s closing yield on Ireland’s 10 year bond had fallen to 3.28%, converging fast with the yield offered by stronger Eurozone countries and only 0.29% above the 2.99% yield on the UK 10 year gilt. Such a small differential between Irish and UK bond yields is a massive turnaround from 2 years ago when the spread was 6.24% (8.25% v 2.01%).
UK gilt yields and swap rates have already increased significantly from their low points early last year and so to some extent the impact of a Bank Rate rise is already reflected in fixed rate mortgage pricing. The bigger questions are when and how quickly will Bank Rate rise, and in particular what market expectations are, and when will they change; these will be material factors influencing gilt and swap rate yields and hence the cost of fixed rate money to lenders when setting their mortgage pricing.
What is very clear is that there is little scope for any fall in the cost of fixed rate mortgages, with any decreases being very modest and largely due to a lender tweaking rates at different LTVs or responding to a competitor change.
Borrowers on historic cheap term tracker rates are unlikely to consider it worthwhile switching to a fixed rate, but will have to hope other lenders don’t follow the path of Bank of Ireland, which now sells its mortgages through the Post Office brand, and West Bromwich in reneging on their term tracker contracts. However, it is unlikely any other lender will risk going down this route pending the FCA’s promised consultation on this situation. When deciding which lender to offer their business to borrowers may want to consider a lender’s previous track record in treating customers fairly.
Looking at the UK housing market, activity will continue to increase this year, with the massive improvement in the availability of 95% LTV mortgages due to the two Help to Buy options (although many 95% LTV mortgages are also offered outside the Help to Buy scheme), despite lending criteria remaining tight. This increased availability has provided an opportunity for both First Time Buyers and movers who were previously excluded from the market due to the lack of an adequate deposit, despite having a good credit status and being able to afford the monthly payments, to participate. Furthermore, activity at the lower pricing levels provides the catalyst for transactions further up the scale to take place.
A common criticism of those who don’t believe anyone should be allowed to buy a home without a deposit in excess of 5% is the risk of default when interest rates rise. This demonstrates a failure to understand some of the dynamics of the market. First of all lenders assess affordability at an interest rate well above today’s levels, typically at around 7%. Secondly, 95% rates are around the 5% level and most lending is from lenders whose SVR is around 4%.
Therefore, if a 95% borrower takes a fixed rate most are in effect insulated from the first 1% rise in Bank Rate, whereas a borrower with plenty of equity taking a sub 2% 2 year fix risks a sharp rise in payments in 2 year’s time. Secondly, now that all high LTV mortgages have to be on a repayment basis, over the first two years of the mortgage, depending on the term selected, around 4% of the capital will be repaid.
Couple this with the probability that the value of most homes will rise by at least 6% over the next two years and in this eventuality the LTV would come down to 85% after only two years. A reduction of even 5% in the LTV would allow a remortgage to rates around 1% below 95% rates and a 10% reduction to 85% LTV would mean rates a whole 2% lower were available, based on current rates. This provides a further cushion against rate rises for 95% LTV borrowers.
If a life changing event such as redundancy or a relationship breakdown occurs the challenges for a 95% LTV borrower will be greater than for someone with a bigger deposit, but this would also be true if they were renting. However, when assessing the risk solely from an increase in interest rates, other things being equal, a buyer with a 95% LTV mortgage is less exposed for the reasons given above.
For these reasons a 2 year fixed rate will make sense for many high LTV borrowers, but one thing they must bear in mind is that many lenders will not allow the fee to be added above 95% LTV and so in addition to needing a 5% deposit and the stamp duty land tax if they are buying at a price in excess of £125,000, they may need to find up to an extra £1,000 to cover the lender’s fee.
For borrowers with a larger deposit, or more equity, 5 year fixed rates are still available under 3%, even at 75% LTV. The differential between 2 and 5 year fixed rates, particularly after amortising over just 2 years the very high fees on the lowest 2 year fixed rates, is relatively small when considered in the context of buying interest rate security for two years, when it is not really needed, or 5 years. The further ahead one looks the more difficult it is to be confident what will happen to interest rates, despite the expectation they will only rise slowly. Therefore a 5 year fixed rate looks the product of choice for lower LTV borrowers.