Buyers' mortgage dilemma

The choice between variable and fixed-rate is currently extremely difficult. Stephen Pritchard reports
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The Independent Online

The last few weeks have seen slight falls in mortgage rates from leading lenders, and City economists believe that the UK interest rate cycle is at, or near, its peak. Even pessimists predict perhaps just one further rise in base rates, before they start to drift down again.

The last few weeks have seen slight falls in mortgage rates from leading lenders, and City economists believe that the UK interest rate cycle is at, or near, its peak. Even pessimists predict perhaps just one further rise in base rates, before they start to drift down again.

For home-buyers, this poses a difficult question. Is it best to opt for a variable mortgage, accepting that rates may rise before they start to fall, or is it better to pick a short-term fixed-rate mortgage?

After a period when it was hard to find much choice of mortgages below 5 per cent, several building societies and banks have two-year deals below that level. Moreover, the premium that lenders demand for a two-year fixed-rate mortgage over a variable rate loan is also low.

Yorkshire Building Society is offering a two-year deal at 4.69 per cent; Derbyshire, through the broker Charcol, is lending at 4.6 per cent.

Among the majors, Moneyfacts lists a two-year fixed-rate mortgage , until 1 January, 2007, at 4.69 per cent with Northern Rock. Nationwide's two-year fixed-rate mortgage is 4.95 per cent, with flexible features, and Halifax comes in at 4.99 per cent.

According to Ray Boulger, senior technical manager at Charcol, any two-year fixed-rate mortgage between 4.9 and 5 per cent is reasonable, but not especially competitive in the current climate.

But a two-year fixed-rate mortgage remains a cheaper option than a five-year deal, and it also keeps the door open to remortgaging, if rates do start to fall again.

Looking at longer-term mortgage rates gives some clues about the trend. Five-year fixed-rate mortgages have started to edge down in line with longer-term money-market rates. On the money markets, the yield curve is currently flat. The "swap" rates used by banks in the wholesale money market show a difference between two-year and five-year swap rates of just eight basis points (0.08 per cent).

This is not yet fully reflected by mortgage rates, however. Charcol calculates that the difference between a two-year mortgage and a five-year mortgage averages 30 basis points (0.3 per cent), with only a handful of lenders offering five-year deals at below 5 per cent.

Charcol has just launched a five-year rate of 4.94 per cent, with Derbyshire Building Society. Stroud & Swindon's five-year rate is just above the 5 per cent mark, at 5.05. But the mortgage has a free valuation, so it might work out cheaper for homeowners taking out a smaller loan. Unless a buyer has a pressing need for certainty, though, the differences in interest charges mean that they are likely to be better off taking out either a two-year fixed-rate mortgage or even a variable-rate loan, rather than committing to a five-year deal.

"Base rates will start to fall in the second quarter of next year. I believe they have peaked," says Mr Boulger. "Economists are forecasting rates of between 4.5 and 4.75 per cent. If you take a two-year mortgage now, you should be able to lock into a new mortgage that is at or below that rate."

He cautions that borrowers who take out a five-year fixed-rate mortgage could even find that mortgage costs are on the rise again, when their fixed deal ends. This, combined with the current higher costs of a five-year loan, makes them a less attractive option.

As an alternative, home-buyers who are very bullish on interest rates could opt for a variable-rate deal now, with a view to switching if rates do come down further.

Abbey has a two-year tracker at 0.3 per cent below base rates, although the maximum loan is limited to 60 per cent of the property's value. First Active has a three-year tracker mortgage, set at the Bank of England's base rate of 4.75 per cent.

For buyers who believe the economists' predictions, this is a relatively low-risk option. "If you get it wrong, the most you will be adrift of the best rates is 0.25 per cent," says Mr Boulger. But he cautions that the most competitive tracker mortgages have tie-ins during the discounted period, so they do not offer much more flexibility than a two-year, fixed-rate deal.

"A two-year fix buys you peace of mind and security," he says. "And you are not now paying such a big premium over a variable rate."

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