Personal Finance: Time to take an interest in falling rates

For thousands of borrowers and savers, last week's quarter point cut in interest rates left a bitter-sweet taste in the mouth. Thousands of borrowers still have fixed rate mortgages, taken out in the mid-Nineties at 8 per cent or more. At the time it seemed a good deal - particularly as experts were warning of high rates if Labour won the 1997 General Election. Now, those borrowers are looking on in envy as variable rates fall to 7.45. Further falls are predicted.

Savers, too, may not exactly be jumping for joy. Those who live on interest from their savings, and enjoyed rates as high as 8 per cent last year, may start to feel impoverished. They are struggling find accounts paying more than 6 per cent: some are looking at a 20 per cent cut in their income.

Despite the gloom for some, there are things you can do about it. Here are some of the options:

How do I guard the income from my savings against further falls in interest rates?

The best rates on instant access deposits are currently around 6 per cent (with some exceptions). Experts predict that rates will fall another percentage point by the end of 1999 - another 16 per cent cut.

Egg, the Prudential's telephone savings and mortgages division, still pays 7.25 per cent gross, though for how long is anyone's guess.

Savers who want to stop their interest income from falling further can lock into reasonable rates of fixed interest. Abbey National offers 5.5 per cent gross, fixed for five years.

What happens if I can't be bothered to shop around forever?

Virgin Direct's Deposit Account offers a rate guaranteed never to be more than 1 per cent below the UK clearing bank base rate - at least until December 2001.

First Active, best known for its highly flexible mortgages, has launched a Fairdeal account, promising the average of the 20 highest-paying instant access accounts on the market. To spice things up, First Active is taking the average interest of the top 20, paid on balances over pounds 10,000 - where rates are usually highest, currently 7.16 per cent gross - but in Fairdeal's case, applying it to a minimum balance of pounds 1,000.

Is there anything else I can do?

Those who do not need access to capital for five years, and who pay tax, could opt for a Tessa. Philippa Gee, of Shrewsbury-based financial advisers Gee & Co, points out that for a higher-rate taxpayer, a Tessa paying 5.5 per cent will beat a taxed investment of as much as 9 per cent.

How can I boost the income paid from my savings?

Savers who are willing to take some risk with their capital can boost their annual income.

Corporate bond funds yielding upwards of 7 per cent are available: Schroders, the investment house, launched one this week. M&G also offers a successful bond fund.

Wrapped inside a PEP, the bond fund looks even better. New tax rules allow savers to reclaim 20 per cent tax on income from the fund. That contrasts with funds investing in shares, which can only reclaim 10 per cent. To match the fund's return, a basic rate taxpayer would have to find an interest rate of 8.75 per cent. For a higher rate taxpayer, the figure would be 11.6 per cent.

Unlike savings accounts, the bond funds do not guarantee capital. The trade-off for a higher income is the - relatively minor - risk of not getting all the money back.

How can I use my mortgage to cash in on falling rates?

People on variable rates may think themselves lucky already. A borrower with a loan of pounds 120,000 has already seen rates fall from an average of 8.95 per cent to 7.45 per cent, a saving of pounds 117 a month.

But there is a limit - or "floor" - to mortgage interest rates.

What do you mean, "a floor"?

Variable rates are predicted to fall by up to 1.25 per cent by the end of 1999, bringing mortgage rates down to 6.25 per cent.

The trouble, according to Ray Boulger, of mortgage specialists John Charcol, is that lenders must still pay money to their savers and make a profit. If savings rates are just a point above inflation - say 3.5 per cent - then after taking a profit margin of 2 per cent, mortgage rates must be at least 5.5 per cent.

Can I take advantage of falling rates?

Shift to a discount mortgage. The Independent Mortgage Collection, a network of mortgage brokers, offers a discount of 2.5 per cent below standard rates.

If standard rates fall to 5.5 per cent, mortgage payments could be as low as 3 per cent. The catch, of course, is that borrowers must stay with the lender for three years after the discount ends, or pay a hefty redemption penalty.

Coventry Building Society offers a two-year discount of 3.5 per cent on its existing variable rate of 7.45 per cent. Again, there are some swingeing redemption penalties to take into account.

What if I already have a mortgage with redemption penalties? Can it make sense for me to switch?

Such is the size of the recent drop in interest rates that it can be worthwhile to pay the redemption penalty, pay the costs of a new valuation and legal fees, and re-mortgage - particularly for those who fixed between 1995 and 1997.

A borrower who took out a five-year pounds 100,000 loan, fixed at 8.5 per cent with the Royal Bank of Scotland would pay monthly payments of pounds 708.33. Redemption penalties, of 6 months' interest, would cost pounds 4,250.

Most lenders will add the redemption fee to the new loan, though beware: over the remaining period of a mortgage, you could be paying as much again in extra interest payments.

Some lenders will also pay other upfront costs - such as valuation and legal fees.

Bank of Ireland Mortgages offers a 4.99 per cent loan, fixed for three years, which includes this. Even after redemption fees and legal fees have been added to the loan, payments are still much lower: just pounds 433.51 a month. The borrower marooned on a high fixed rate of interest has saved pounds 275 a month for three years, a potential gain of about pounds 5,000. And when the fixed-rate period ends, the UK is likely to have joined the European Single Currency, so interest rates could be even lower.

For those who want to keep things simple: Northern Rock is offering a "cashback" of up to 8 per cent of the value of a loan, set at its variable rate - though you will pay heavy penalties for redeeming it in the first seven years.