Rate rise could be shocking for borrowers

Mortgage borrowers benefiting from record low interest rates could be in for a rate shock next year. Experts warn that interest rates could start climbing from next spring, leaving borrowers on variable rates forced to dig deeper to meet monthly mortgage commitments. There are several tactics borrowers can adopt to ease the effect of future rate rises, but should you think about taking action now?

With fixed-rate loans reaching record lows, it could certainly prove a good idea to tie your mortgage down now for the next few years. "As rates have fallen to historical lows people should be taking advantage of some of the attractive fixed rates on offer," suggests mortgage adviser Andrew Montlake of the Coreco Group. "While it is nice to be on a low tracker rate, this can change quickly and people have to be sure they can afford not just a 1 per cent rise, but possibly a 2 per cent rise in rates over the next year or two."

On Thursday a five-year fixed rate aimed at people remortgaging was launched at a new low of just 3.69 per cent. The deal from ING Direct is only open to those with 60 per cent equity in their home and has an expensive fee of £1,945. But it's just the latest in a flurry of lower fixed rates that have hit the market in recent weeks. According to Moneyfacts, the average cost of fixed-rate mortgages fell to new record lows during September. The typical cost of a two-year fixed rate deal fell to 4.4 per cent, while three and five-year fixed rate deals fell to 5.04 per cent and 5.36 per cent.

Fixed rate mortgages can be attractive in that they offer you certainly of knowing how much your mortgage repayments will be for months or years in advance. But fix too high and you could easily end up paying more for your mortgage than if you'd remained on a variable rate. The problem is that we don't know how quickly and by how much rates may go up.

Is it likely that rates could leap to the levels we saw before the credit crunch, when the base rate stood at 5.5 per cent and mortgages rates of 7 per cent were not uncommon? No, thinks Drew Wotherspoon of mortgage advisers John Charcol. "The chances of rate rises has arguably receded further over the last month or so, with the general recovery weakening and the focus of the MPC turning toward printing more money. I expect the first rate rise to come towards the end of 2011, but for any increases to be very gradual over the coming years. We simply cannot see the big rises some commentators are forecasting," he says.

David Hollingworth of rival brokers London & Country Mortgages agrees that a rate increase is some way off. "But the only direction that base rate will move is up and so borrowers should be considering how they will approach the situation and how well they will cope when the time comes," he warns.

The gap between the very best variable rate at 2.5 per cent and ING's five year fix at 3.69 per cent is now slim which strengthens the argument for fixing. "Only the most bearish would suggest that rates will not rise by more than 1.19 per cent over the next three years," says Andrew Montlake. "A little extra cost now could save many a sleepless night in the future."

Melanie Bien, of independent mortgage broker Private Finance, points out that fixed rates are unlikely to get much cheaper. "If you wait until interest rates are rising before you fix, you will pay more than you would now, because the pricing of new fixed rates rises accordingly," she says. But that's not reason alone to switch from a variable to a fix, she says.

"Trying to time the market and an interest-rate rise is a mug's game; you should really opt for a mortgage that suits your particular circumstances. So if you are on a tight budget and like certainty, a fixed rate makes sense. If you can afford fluctuations in interest rates, a base-rate tracker may be cheaper at least initially. Or consider the best of both worlds – a tracker mortgage with the option to switch to a fixed rate at any time, without penalty," Bien advises.

Wotherspoon advises against fixing now. "It is entirely down to the profile of an individual borrower, but the better value is still currently had in the tracker market," he says. "They are priced lower and I do not believe there will be sharp interest rate rises that would make it worthwhile taking the more expensive fixed rates. The time to take fixed rates will come again, I just don't believe it is now."

However, his firm does offer an alternative way to protect yourself against future rate increases: an Interest Rate Protector. "It's similar to insurance," Wotherspoon explains. "You pay for it, and you may never actually get anything back from it if you do not have to claim, but it provides peace of mind. It is also a solution for those who are unable to remortgage due to restrictive lender criteria or high loan to values and are concerned about future rate rises."

However, it's not cheap. The rate changes but currently works out at around £10,000 to cap a five year mortgage at 5 per cent. That's the equivalent of around £170 a month on top of existing mortgage commitments. As such, it's only really suitable for those with large mortgages, of £500,000 or more.

Islay Robinson of mortgage brokers Enness Capital specialises in higher-value mortgages. He says there has been a huge increase in the popularity of interest rate caps, which he arranges through bank treasury departments. "They can be a good alternative to a fixed rate and, depending on your loan amount, can work out cheaper than remortgaging," he says. "As they run independently from the mortgage they can even be used by those in negative equity or people with buy-to-lets which are difficult to remortgage."

For the average borrower there is instead a cheaper insurance policy you can take out. Chris Taylor of MarketGuard says his RateGuard cover could be particularly useful to people who can't remortgage. "Many mortgage holders would be unable to find a suitable fixed deal and would remain at the mercy of the financial markets," he says. "Cover can be arranged from as little as £30 per month for 24 months cover based on a typical repayment mortgage of £100,000." So if you're on a 3.5 per cent variable rate, for instance, you could get cover for the mortgage rate reaching 4.5 per cent with the insurance paying out when that happens. It would mean that even if rates did climb higher, mortgage repayments would remain affordable while the cover was still in force.

But rather than paying out for insurance you could instead overpay your mortgage. If rates rise then you would already be used to paying extra. "For many people on very cheap variable rates who don't want to move onto a more expensive fix at this stage, using the money you are saving to overpay on the mortgage and then switching to a fix when rates start to rise, can be a better strategy," says Melanie Bien.

If you can afford to overpay, you shouldn't get too carried away, advises David Hollingworth. "It's important to check that there will not be any early repayment charges by overpaying and it's important not to plough all savings into the mortgage and retain an amount of easily accessible cash."