Why is the Bank of England so Important to Personal Finances?
While many people associate base rates with their mortgage rates, the devil is in the details. To understand the direct relationship, it is essential to appreciate the Bank of England's role and why it is so crucial to businesses and individuals.
Setting interest rates
UK base rates currently stand at 5.25%, with expectations that we will see several reductions throughout 2024. The Bank of England sets the base rate based on various economic indicators. We often hear talk of base rates, but what does this relate to, and how does it impact, for example, your everyday mortgage rate?
Risk-free lending
Many people will be surprised to learn that the base rate is the interest rate paid to commercial banks that hold funds with the Bank of England. This includes the likes of Barclays, Santander and Royal Bank of Scotland; those banks authorised to provide banking services in the UK financial services sector.
So, the current Bank of England rate of 5.25% is seen as the "risk-free" interest rate on which other financial arrangements will be based. While nothing is ever risk-free, in this instance, the Bank of England is as close as you will ever get.
For example, with a mortgage rate, your lender will need to take into account the:-
- Risk factor
- Base rate (risk-free lending rate)
- Business costs
- Profit margin
Consequently, it makes no commercial sense to offer a mortgage with a standard variable rate of 3% (including all of the risks) if your lender could receive 5.25% by holding deposits with the Bank of England. To put this into context, the average standard variable rate on a mortgage currently stands at 8.18%. At 2.93 percentage points above the Bank of England base rate, this reflects the above-mentioned factors.
Risk premium
The premise of any financial transaction is the comparison between risk and potential reward. This is why mortgage lenders will charge a higher rate for an arrangement with a higher loan-to-value (LTV) ratio. In effect, your deposit is a type of insurance policy for your mortgage lender against market movements. For example, if you paid a 20% deposit, and your property was devalued by 10%, if you were to default, the property could be sold, the mortgage repaid in full, and surplus funds could still be left.
If you only paid a 10% deposit, and your property devalued by 20%, this would tip you into negative equity. The property's value would not cover the outstanding mortgage, thereby increasing the risk that the lender would lose on this transaction. When assessing a risk premium, there are various other factors to consider, but this is perhaps the least complicated example.
Real impact on mortgage rates
Historically, mortgage companies have used the yield on UK gilts as an indicator for fixed rates, with standard variable rate mortgages more closely associated with base rates PLUS a premium. A gilt is an IOU issued by HM Treasury to raise funds to maintain liquidity and ensure the smooth running of the UK government. In exchange for buying gilts, investors receive interest payments (generally fixed) specified upon issue.
The yield on a 10, 20, and 30-year gilt is seen as “low risk” (backed by the government) as opposed to the effective "risk-free" rate paid by the Bank of England. Consequently, the mortgage industry uses gilt yields as a barometer of future mortgage rates.
In the disastrous Conservative mini-budget of September 2022, uncosted tax cuts sent a shiver through money markets. In just a matter of days, the yield on the:-
- 10-year gilt hit 4.632%
- 20-year gilt jumped to 5.19%
- 30-year gilt increased to 5.01%
Amid speculation that the Bank of England would be forced to increase base rates from 2.25% to as high as 6% by the summer of 2023, the average two-year fixed mortgage rate hit 6.46%. This is compared to a rate of just 2.25% in October 2021.
What does this mean for your mortgage payments?
To put this into perspective, let us look at a homeowner with a £130,000 standard variable rate mortgage payable over 25 years. A mortgage rate of 2.5% equates to a monthly payment of £583, with each subsequent 1% increase in the mortgage rate resulting in a further £168 per month.
A two-year fixed-rate mortgage was set at 2.25% in October 2021, whereas today, the rate is 5.76%. This would increase monthly mortgage payments from £583 to over £1100!
Money market movements make a difference!
While many of us ignore money market movements, they are useful indicators of short, medium, and long-term mortgage rates. As we saw in September 2022, with the mini-budget, uncosted tax cuts significantly increased the risk associated with UK government finances. The knock-on effect on the mortgage market saw many household budgets stretched to their limits. and beyond.
Summary
While many of us have a broad understanding of how base rates impact mortgage rates, the devil is very often in the details. Even though much of the focus tends to be on the Bank of England, more often than not, it is money markets that best indicate changes in short, medium, and long-term mortgage rates. There are many different factors to consider, but if you want to monitor the direction of mortgage rates, keep an eye on the money markets.
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