How will an interest rate rise affect my mortgage payment?
How will an interest rate rise affect my mortgage payment?
Why are interest rates increasing?
We have all become used to historically low interest rates here in the UK, which has made the cost of borrowing money to buy a home, car or anything else using a mortgage, bank loan or credit card relatively inexpensive over the longer term. However, with the cost of goods and services rising quickly (inflation), the Bank of England and the British government are taking steps to reduce demand (and therefore prices) by increasing interest rates.
In theory, if interest rates increase, borrowing becomes more expensive and our mortgages, loans and credit cards all cost more each month. This increase in the cost of borrowing limits the amount of disposable income consumers have and will also make people reconsider if they are going to move house, buy a new car or go on holiday - therefore reducing demand for goods and services and (hopefully) causing prices to fall. The tricky bit for any government is to put in place policies that reduce inflation but don’t stagnate economic growth - a tricky tightrope indeed.
We have information on inflation, the Bank of England and stagflation in other articles, if you want to know a bit more about these topics.
Are high interest rates good or bad?
High interest rates are bad for those that need to borrow money to buy a home or take out a bank loan as the monthly payment will be high as there is a greater cost of borrowing. However, high interest rates are great for those that are looking to save money or buy bonds as the banks and bond issuers will pay a higher amount of interest for your deposit.
A short history of interest rates in the UK.
As mentioned earlier, we have all become used to low interest rates in the UK. However, anyone that was an adult in the last century will regale you with stories of how high the interest rate was on their first home purchase or how their old savings account used to pay an above inflation rate on their cash deposits.
Bank of England base rate historical data 1971 - 2022 (Source: Trading Economics)
As you can see from the chart above, the interest rate picture before the Global Financial Crisis of 2007/8 was much more variable than it is today and would typically trend around the 5% mark since the mid-1990s but peaking around the 17% mark in the early 1980s. bear in mind that these figures are the bank of England Base Rate, the actual cost of borrowing is often many percentage points higher than this, as evidenced in the chart below.
Average mortgage interest rate UK 2000 to 2022 (Source: Statista)
How do interest rates affect mortgage payments?
A mortgage is simply the name for a loan used to buy a house and in reality, is little different to a normal bank loan or credit card. The main points to note are:
A mortgage loan is typically secured against the property - if you can’t make the repayments, the lender may repossess the property.
A mortgage repayment each month covers the cost of repaying the original amount borrowed (the principal) and a charge to borrow the money (the interest). (Interest-only mortgages only repay the interest each month.)
A mortgage is often spread over decades, rather than a few short years, so a small rise in interest rate can increase the amount paid for the house dramatically over time.
To illustrate, at the time of writing, the average house price in the UK is approximately £300,000 (source) and the typical deposit requirement (the amount you have to pay in advance) has been around 10% of the purchase price. With these figures in mind, an example mortgage deal could look like this:
Purchase Price: £300,000
Deposit Required: £30,000
Mortgage Loan Principal: £270,000
Repayment Period: 25 years
Mortgage Type: Repayment
Now we need to factor in the interest rate to calculate the monthly repayments, which you can see in the table below. As you can see, they rise very quickly, particularly in the other examples where the original mortgage loan is much higher.
Mortgage payments if interest rates rise. (Source: Money Helper Mortgage Repayment Calculator)
Money Helper has a really useful calculator that you can use to get a clear picture of how an increase in interest rates will affect your mortgage repayment.
How to protect yourself from rising interest rates (fixed-rate vs variable rate)?
One way to insulate your household budget from rising interest rates and the effect they will have on your monthly mortgage repayment is to move onto a fixed-rate mortgage when you can. You can typically fix the interest rate on your mortgage for 2, 3, 5 or 10 years which will give you certainty when it comes to budgeting for your monthly mortgage repayment.
By contrast, if you have a variable-rate mortgage, every time the Bank of England announces an interest rate increase, your mortgage lender will increase your interest and you will end up paying more from your next payment. If there is a rapid succession of interest rate increases, your regular payment could increase frequently with very little time for you to prepare for the increased cost.
You can read our article on fixed-rate mortgages vs variable rate mortgages for a more in-depth comparison.
Our team of friendly mortgage advisers is on hand to help you understand your options by comparing your current mortgage deal against what else is out there currently on the market. Switching mortgages could save you money in the long run and give you certainty in your monthly budgets. Although based in Tunbridge Wells, we advise clients across the UK.
Conclusion.
There are three things evident from this article:
Interest rates have been very low for decades and cheap money has enabled house prices to grow significantly.
Inflation is growing and interest rates will have to be increased to suppress it.
With mortgage loans being so large, any increase in interest rates is going to have a significant impact on households’ disposable income.
The biggest challenge now is for our political leaders to fight inflation by adjusting interest rates and introducing other policies in such a way that they don’t harm economic growth, cause companies to stop investment, resulting in job cuts and eventually leading to a rise in mortgage defaults and repossessions. With inflation at levels unseen for decades, family budgets at all levels are going to be pushed and any substantial rise in interest rates could cause untold problems.
What’s next?
If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers information about mortgages and should not be taken as personal advice. Think carefully before securing debts against your home. Your home may be repossessed if you do not keep up repayments on your mortgage or any other debt secured on it. This article also offers information about investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.