If you're taking out a mortgage for the first time or remortgaging, you have a crucial decision to make. One that's apart from choosing which lender to go with, how much deposit to put down, and all the other important decisions you'll encounter. The key decision is whether to go for a fixed-rate mortgage or a variable one. Choose wrongly and it could cost you hundreds in extra interest charges. And infuriatingly, there's no way to know now what the right decision will be.
To put it simply, if you choose a fixed-rate mortgage and interest rates remain low, you could end up paying more than you need to for your mortgage. But if you go for a variable or tracker mortgage and interest rates rise, then you could end up with a much more expensive monthly mortgage bill.
It's a gamble. There is no one who can tell you when interest rates will climb. They will rise, most economists and market commentators agree, but whether that's in the next couple of months or not until the end of next year is anyone's guess.
Rates have been kept at historical lows for more than a year with the Bank of England keeping the base rate – which tracker mortgages follow – at an unprecedented 0.5 per cent. With the latest inflation figures showing an increase and the coalition Government announcing massive cutbacks in spending, there could soon be pressure on rates to go up.
Betting on that, however, would be foolish. In fact, mortgage borrowers are currently betting on interest rates remaining low for some time to come, according to a survey by the specialist lender Paragon Mortgages. Its research shows that the proportion of mortgage borrowers opting for a tracker mortgage has overtaken fixed-rate deals for the first time in a year.
"The proportion of borrowers opting for tracker mortgages has been growing since last summer as borrowers look to take advantage of low interest rates," says John Heron, managing director of Paragon. "Although there are some good fixed-rate deals available, the average rate on fixed-rate deals is still significantly higher than the Bank of England's interest rate, and they are becoming less popular with borrowers. It also appears that borrowers believe base rates will remain low for the foreseeable future."
That belief may be based more on wishful thinking than on any knowledge about what will happen to rates. Of course, borrowers would prefer rates to remain low: it means monthly mortgage costs are much less. But anyone taking out a low-rate deal needs to consider what would happen if rates did suddenly climb. Just over 20 months ago, for instance, the base rate stood at 5 per cent. If rates were to return to those sorts of levels, anyone taking a low-rate tracker now could see their monthly mortgage cost doubling – or even worse.
"Unless you are the proud owner of a crystal ball, knowing when, and by how much, rates are going to rise is a tough call," says Drew Wotherspoon of the mortgage advisers John Charcol. "The latest inflation figures point towards rates staying low for some time yet, but if we have learned anything from the past few years, it is that things can change quickly."
He says that the difference between fixed-rate mortgages and variables in pricing is currently around 2 per cent. "That means you would still be paying a big premium if you chose to fix now," he warns. He suggests that people need to make up their own mind, and take advice from mortgage experts about their options. "What is clear is that no generic advice will do," says Wotherspoon. "Borrowers should seek specific advice about their situation to see which product is right for them now, and in the future."
Thinking about the future – not just about now – is important when deciding what kind of mortgage to take out. For the reasons mentioned above, there is a risk in taking out a variable-rate deal – such as a tracker – that could lead to mortgage payments becoming unaffordable if rates were to soar. For that reason, many people like the certainty of a fixed rate, as they know how much their monthly mortgage will be in two, three or five years, depending on the length of the fix. But there are also variable deals which can be linked to a degree of certainty.
"While fixed-rate products give borrowers with a specific monthly budget peace of mind that their payments will always be the same, many products which track the bank base rate also offer greater flexibility," says John Hughes of the Britannia. "For instance, we have the choice of a capped-rate tracker which offers borrowers the best of both worlds – the flexibility of a variable rate, but also a guarantee against future rises."
Another approach is to offer a hybrid mortgage with a mixture of both variable and fixed options. HSBC has gone down this road. Its split loan mortgage allows borrowers to fix a proportion of their mortgage, while the rest of the loan remains variable, tracking the Bank of England base rate for the life of the loan. The loan is designed to appeal to people worried about the dilemma of whether to keep tracking, or benefit from the security of locking into the historically low fixed mortgage rates.
"Other options that act as a hybrid would be to mix and match fixed and variable rates, capped tracker mortgages or perhaps a 'switch to fix' option that allows the borrower to hop out of a tracker on to a fix without incurring a penalty," says says David Hollingworth of mortgage broker London & Country. "Nationwide and RBS both offer the latter as an option although there could be arrangement fees applicable at the outset and when switching to the fixed rate."
Such moves are typical of the increased competition that has hit the mortgage market in recent weeks, giving borrowers more choice of deals than for some time. "With competition once again beginning to stir the mortgage market, there are now some excellent fixed rates available which are beginning to turn people's heads," points out Andrew Montlake of mortgage advisers the Coreco Group.
"While the best trackers are now just under 2.5 per cent, two-year fixed rates are now around the 3 per cent level and there have been some decent four-year fixed rates at around 4 per cent. Deals like this are helping the remortgage market to start moving again as many people begin to feel like they have won by sitting on a lender's standard variable rate up until now and do not want to take any further risks."
Montlake feels that borrowers need to think carefully about how they would be able to cope if interest rates rise. "The difficulty is in trying to predict the exact time that fixes will not get any lower and interest rates are about to rise. Once that first change in bank base rate occurs, no doubt there will be a panic rush to the sanctuary of a fixed by many who may already have missed out on the best fixed rates available now," he predicts.
"As ever, it should not be a case of whether trackers are better than fixes in general, but depends on each person's circumstances and whether paying slightly more now will prevent sweaty, sleepless nights in the future," says Montlake.
Choosing between the different mortgage options is tough, says London & Country's Hollingworth. "Whether to go for variable loan or fix the rate is the perennial dilemma for borrowers, but with such extraordinary market conditions over the last few years the decision has perhaps never been tougher," he says.
"Base rate is at a record low, which spells only one thing – it must rise at some point. That will certainly focus many borrowers on securing their rate so that they protect against future rises. However, that could in many cases see borrowers having to opt to switch on to a higher interest rate, as fixes are higher than corresponding variable mortgage deals. The question therefore becomes centred on when base rate is likely to rise," says Hollingworth.
Britannia's Hughes says the near certainty of a base rate rise could make a strong argument for fixing, but if the rise is still some time away, the variable would remain a good option. "As the lowest ever bank base rate enters its fifteenth month, many feel it's only a matter of time before it starts to climb, which may draw people to fixed-rate mortgages. However, it's unlikely that base rate will increase dramatically, so someone opting for a tracker mortgage could continue to benefit from low rates for some time," he says.
Hollingworth agrees. "Forecasts currently expect the base rate to remain at low levels for at least the short term, which suggests that a tracker deal could be a good option. However, no one really knows what is going to happen and borrowers need to select the right product for their circumstance. While those with an ample budget to deal with rising monthly payments may prefer to take their chances on a tracker deal, those that would feel rate hikes more keenly may prefer to take a safety-first approach with a fixed rate."
He suggests it's a good idea to "stress-test" your budget to see how much your monthly mortgage payment would be following rate increases of 1 per cent, 3 per cent or even more.
"That may help reach a decision over whether a fix carries more attraction," he says. "Hanging on to a variable rate now, and then trying to bag a fix later could be an option, but be warned that when it becomes clear that rates are on the up, fixes will already have increased."
It's also a good idea to overpay your mortgage now if you're on a low variable rate. It will help you deal with rising rates further down the road, and it will have the added benefit of paying off more of the outstanding loan, which can mean cutting the length of the loan as well as cutting the overall cost of the mortgage. However, it's important to check with lenders before making overpayments as some deals don't allow it, and it may even trigger early repayment penalties which could end up costing you a packet.
It's all a part of the far-from-simple range of decisions you need to make to ensure you get the right mortgage deal for you, at a price you can afford now and, crucially, will be able to afford in an uncertain future. Fixed rate or variable? The choice is yours.