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Guide to mortgages in a low-interest environment

Lee Travis - Society of Mortgage Professionals, Head of Professional Development

The guide explores what shapes mortgage rates, what will happen if the Bank of England reduces the base rate to 0 per cent and what advice you should give clients in the current low interest rate environment.

What impact does the base rate have on mortgage rates?

As a result of a reduction in the base rate, existing borrowers on base rate tracker mortgages will see their interest rate go down in line with the Bank of England (BoE) rate, unless a collar/floor is applied by the lender.

Meanwhile, standard variable rate (SVR) mortgages may go down at the lender's discretion and discount rate mortgages may also go down (depending on any changes to the lender's SVR since these types of mortgages usually track SVRs), unless a collar/floor is applied by the lender.

However, fixed rate mortgages will remain as per the terms and conditions of the original contract, offering borrowers the stability they initially applied for.  

For new borrowers, if a saving of a lower Bank of England (BoE) base rate is passed on by lenders to their products, borrowers of new mortgages will see cheaper interest rates than they could have expected before the decision was made to reduce the BoE base rate. This could apply to both variable and fixed rate deals.

The opposite would generally be true of an increment in the base rate.

Do lenders have to pass on the base rate cut?

For base rate tracker mortgages, yes they are obliged to pass on the savings as per the terms and conditions of the original mortgage contract (unless a collar/floor is applied).

SVRs (and therefore discount rate mortgages providing no collar/floor is applied) may go down. These types of mortgage rates generally follow market conditions, but can be at the lender's discretion.

In the aftermath of the financial crisis, some SVRs did not fall in line with the BoE rate. However, the recent base rate decision has the added benefit of the term funding scheme, which will enable lenders to borrow money at or close to the new 0.25 per cent base rate - therefore incentivising them into passing the savings on to consumers.

Lenders may also come under pressure to pass savings on because many competitors quickly announced rate reductions following the BoE decision.

The important consideration will be the date that any savings are passed to consumers, because this would not necessarily be immediate (for example it could be the month following the BoE's decision to reduce the base rate).

What other factors have an impact on mortgage pricing?

Savings rates:a factor that affects mortgage pricing is the rate at which lenders borrow money from depositors. With savings rates already so low, lenders may struggle to squeeze much more margin from savings rates (even though savings rates are expected to fall further).

Furthermore, with the BoE injecting capital into the market, lenders are unlikely to increase savings rates as demand for saver deposits will remain low. Therefore, whilst savings rates could be an influence to mortgage pricing, this factor is unlikely to have a significant impact on the pricing of mortgage rates at this particular time.

LIBOR rates:this is the rate at which banks lend to each other, and is usually a good indication of banks' confidence in each other. Changes in the LIBOR rate usually impact on the pricing of short-term mortgages. The LIBOR rate has been fairly stable since the EU referendum vote, potentially because of BoE's quantitative easing measures. For this reason, whilst short-term mortgages may become cheaper, the impact of LIBOR rates at this time is unlikely to be considerable.

Swap rates:in short, these are contracts that the lenders enter into in order to counter the risk of losing out by lending money on long term fixed rates. Lenders essentially borrow money from savers and lend it on for a profit. In order to ensure no loses are incurred by lending this money on a long term fixed rate (the risk being that interest rates could increase more than anticipated on savings rates - thereby reducing the lenders margin), lenders will enter into swap contracts, with parties of the opposite needs. Following on from the result of the EU referendum, swap rates plummeted. This could be seen as a good indication that longer-term fixed rates are due to get cheaper.

Lenders' risk appetites:any factors that affect mortgage pricing do not generally do so in isolation. The factors stated above usually interlink to impact on lenders' mortgage pricing strategies. Additionally, lenders have their own risk appetites and profitability targets to consider. If property prices are expected to fall in the wake of the UK's decision to leave the EU, lenders may start to price higher loan to value mortgages differently to something that may be considered lower risk.

Inflation:ultimately there is one factor that influences most, if not all of the above: inflation. The BoE base rate is set by the Monetary Policy Committee (MPC) to enable inflation targets to be met. Whilst this particular objective seems to have been abandoned somewhat in the wake of the 'Brexit' vote, inflation (which has recently crept up to a 20-month high) could cause rates to go the other way.  

What impact should the prospect of zero per cent base rate have on the mortgage advice market?

It is unlikely that there will be huge implications for the mortgage advice market, although this should be viewed as positive news.

Clearly, what will happen to lenders' products and criteria remains to be seen, but from an adviser's point of view, little may change. Consumers seeking advice will still expect advisers to have relevant market knowledge and the ability to assess their situation and make suitable recommendations in these unprecedented times.  

The recent change to the BoE base rate may have already prompted many existing and potential borrowers to seek/re-seek advice. This change should also have been used as an opportunity by advisers to get in touch with their existing clients to ensure borrowers are aware of the changes, what it means for them and whether making any changes to their mortgage would be worth exploring.

An even lower base rate at zero per cent could be used as a further prompt for advisers and clients to reconnect and possibly make further savings. 

What impact will the reduced base rate have on lender profitability?

Lenders' profits will probably diminish, due to losing out by reducing variable rates for existing mortgage holders. Additionally, their future profit margins may also be reduced, due to having to offer new mortgages on lower rates.

However, lenders will take some comfort because the blow will be softened owing to measures already taken by the BoE. Furthermore, there is likely to be more economic stimulus provided if and when it is required.

The good news is that lenders will have the capacity to absorb these losses in profits, or else they would not be as keen to reflect the BoE base rate savings to consumers. 

What impact will the reduced base rate have on the mortgage market?

Advisers and consumers:as mentioned above, the reduction in the base rate will have prompted many consumers to seek advice. It is also a good opportunity for advisers to contact clients to ensure they continue to meet their needs.

Variable rate (base rate tracker, many SVR and discount rate) mortgage holders will be enjoying lower monthly payments and any saving could be utilised to ensure that client's protection needs are fully met. They may also benefit from a mortgage review, as it could be beneficial for many consumers to fix their mortgage rates at this historical low.

Likewise, fixed rate mortgage holders may also benefit from advice. Due to mortgage rates dropping even more, it may now be worth paying any early repayment charges to have a lower mortgage interest rate - saving money in the long term. 

Lenders:as interest rates squeeze mortgage lenders even closer together in what is already a highly competitive market, lenders will need to set themselves apart somehow to acquire business and make up for lost profits.

There have already been some really exciting innovations in the mortgage market this year, a great example of which is 'intergenerational' mortgages. A reduction in the base rate will only help to keep this trend going.

We are also likely to see the launch of new products, such as the recent plethora of 10-year fixed rate mortgages.

With cheap money available to lenders, they may even venture into longer term fixed rates, especially with the benefit of the term funding scheme made available by BoE as part of the most recent economic stimulus package.

What impact will this have on affordability calculations?

Affordability is likely to become better for consumers if the rate reductions are passed on to stress tests. This is illustrated by a high street lender recently announcing that their stress test will be reduced by 0.25 per cent.

The importance of stress tests, particularly affordability, came to the fore after the introduction of the Mortgage Market Review (MMR). Lenders are required to ensure that they assess a borrower's ability to repay a mortgage now, and in the future. This means lenders should be taking the impact of potential future interest rate rises into account.

MMR requires lenders, when assessing affordability, to apply an interest rate stress test that assesses whether borrowers could still afford their mortgage if, at any point over the first five years of the loan, bank rate were to be three per cent higher than the prevailing rate at the beginning. A reduction in the SVR could reduce the stressed interest rate a lender must apply, hence improving affordability.

In addition to the above, if a mortgage is fixed for five or more years, the pay rate can be used as the stress rate. Therefore instead of using a stress rate of seven per cent for instance, lenders could choose to use a stress rate much lower than this (a good five-year fixed rate can currently be obtained for around two per cent). With low five-year fixed rates, many new ten-year fixed rates and potentially room for even longer fixed rates, stress tests could become much more lenient.  

Could mortgage fees be set to increase?

At this time, this is a big unknown because we are yet to see fully how lenders are going to respond to all of the recent market activity. On one hand, in an environment where profitability is reducing fast, it would not be surprising to see lenders increasing their fees. They may increase fees and reduce rates to maintain profitability whilst keeping the best headline mortgage rates.

On the other hand, the mortgage market is fiercely competitive and there are currently no signs of any slowing down. It is arguable that lenders will not want to lose their competitive edge by increasing fees.

What should mortgage advisers do to make sure their clients are getting the best deal in the current base rate environment?

This is the ideal opportunity for mortgage advisers to reconnect with clients and offer a full review to ensure needs are continuing to be met and best client outcomes are being achieved.

Additionally, it is as important as ever for advisers to carry out relevant and suitable CPD. Advisers should keep abreast with all of the market changes to ensure that they are knowledgeable and confident in talking to their clients about all of the recent market developments.

Advisers should also be aware of different lenders' product and criteria changes, so that they know where clients' applications can be best placed. Many lenders (existing and new) have come to the market with unique ways of helping clients with more intricate needs. The specialist lending market has been booming. Equity release, limited company buy-to-lets, bridging and development finance are just some of many alternative ways of meeting borrowers' needs.

Knowledge of the market will give advisers the ability to ensure their clients receive well-rounded, comprehensive advice. Even if advice cannot be provided in a specific area, advisers should be able to identify needs and refer clients on to specialists if relevant.