From credit ratings to ‘swaps’, what determines the interest rates lenders set on their mortgage deals?
When the time comes to select a mortgage, there are few more important considerations than the interest rate.
After all, the interest rate plays a huge part in determining the size of your monthly repayments and how much it will eventually cost you to clear the loan in its entirety.
Yet very few of us understand how lenders set these rates, and the various factors that influence them and determine whether they will go up or down.
One common misconception is that the base rate, set each month by the Bank of England’s monetary policy committee (MPC), is a big driver in the rates that we pay for our home loans.
This isn’t really true though.
What really drives it?
Base rate has barely moved in the last decade, and yet we have seen significant movement on the rates charged by lenders. For example, according to Moneyfacts the average interest rate for borrowers with a 10% deposit on a two-year fixed deal has dropped from 4.8% in 2013 to just 2.65% today.
That said, if base rate moves, it may have a direct impact on the size of your repayments. Tracker deals, as the name suggests, track the base rate. So your rate might be base rate plus 1%, which would mean at the moment an interest rate of 1.75%. If base rate was increased to 1%, then your mortgage rate would rise alongside it to 2%.
If you are on your lender’s standard variable rate (SVR) – the rate lenders move you to once your initial fixed or tracker rate finishes – then these will usually be hiked up following a base rate move too, though the lender isn’t limited in how much they can increase the SVR. In other words, even if base rate only goes up by 0.25%, your mortgage rate could go up by more.
However, if you are on a fixed rate mortgage, your rate won’t be impacted at all by any change in the base rate.
What about wholesale costs?
With many things we buy, from the petrol we put into our cars to the gas and electricity we use to power our homes, the price we pay is significantly influenced by the wholesale costs.
In other words, the more that the supplier has to pay to get hold of that fuel, the more we then pay in order to purchase it from them. In theory, when the wholesale costs go down, that should make it cheaper for us to buy too, though in reality that doesn’t always happen.
It’s much the same with money. Mortgage lenders don’t always have huge pots of cash just waiting to be lent out – they might need to bring in some financing through the wholesale markets, to then lend out with a little on top for the sake of their profits to us borrowers.
As a result, the cost of bringing in those funds play a huge role in determining what rates lenders are able to offer on their mortgage deals.
The protection of swap rates
These are a little complicated but basically allow lenders to protect itself against the risks of the interest rates it pays on accessing funds moving out of step with the rates it charges on lending that money out.
Think of it this way – if the lender is committing to lending out money at 2% on a two-year fixed rate mortgage, it wants to be able to protect itself against the cost of raising that money moving above 2%. Lenders include the cost of these ‘swaps’ when pricing up deals – as it becomes more expensive to hedge, then its mortgage rates rise too.
How risky are you?
A big influence on the interest rate charged on different mortgages will be how risky the target borrowers are likely to be.
This can take a couple of different forms. For example, if you have a larger deposit you’re seen as less of a risk by lenders, so you’ll tend to enjoy much lower interest rates than the deals on offer to borrowers with a deposit of just 5-10%
Similarly, while most lenders restrict their deals to borrowers with near-spotless credit histories, there are some products which are designed for people who have been through CCJs and have a less than perfect record. These deals will come with higher interest rates though.
How much competition is there?
Competition is definitely a good thing for mortgage borrowers.
Not only does it mean you have more deals to choose from, but lenders are pushed towards lowering their rates – and making less of a profit – on their products, in order to try to stand out from the competition.
The mortgage arrangement fee
The interest rate isn’t the only way that a lender makes money from its mortgage product. Borrowers will also generally have to pay an arrangement fee, or product fee, in order to secure that deal.
These can vary sharply in size on residential mortgages, from nothing at all to almost £2,000.
Mortgage deals with the lowest interest rates tend to come with more significant product fees, while you’ll have to commit to a higher interest rate in order to secure a fee-free deal. These fees can be paid all in one go, or added to your mortgage balance. Just remember that if you do so, you’ll be paying interest on it along with the rest of your loan, so it will end up costing you far more over the long term.
By John Fitzsimons
09:00, 14 APR 2019