Tie your mortgage deal down: The fall in borrowing costs may soon tail off so the time is right to fix the interest, says Peter Rodgers

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The Independent Online
BOND and share markets have fallen, professional investors are nervous, and pundits are in greater disagreement than usual about the economic outlook. This might be the sign of a turning point for interest rates and a rise in inflation, after two years of steady falls.

So is it time to lock into a fixed- interest mortgage for the next few years in case rates should rise again to double digits?

The shortest-term UK rates, such as the bank base lending rate, have fallen and may drop again and it is possible that interest on ordinary variable mortgages could slip a little further.

But longer-term interest rates have risen over the past month in the UK and the US. A tightening of monetary policy by the US Federal Reserve has reminded investors that inflation may not, after all, be dead - and interest levels reflect the market's expectations of inflation.

The price of fixed-rate mortgages from banks and building societies is, in effect, set by the longer-term rates on offer in the market for investments from two to 10 years (and occasionally as long as 25 years).

If market rates are on the rise again (see chart), could today's fixed-rate mortgage offers be the last we shall see at such low levels for a while?

The rise in long-term interest might, of course, be no more than an unthinking reaction to the scare in the US, suggesting the downward trend in the cost of money in Britain will resume shortly. That argues against rushing to take out a fixed-rate mortgage if there is any chance of further benefits from lower variable rates.

But for their longer-term decisions - even on sterling interest rates - many bank strategists look to movements in the US long bond rate as the most consistent indicator of changing trends in other markets. This is why the change of sentiment in the American markets since the new year is so important.

The links are loose, and some influential UK pundits believe they are breaking. It is, nevertheless, a courageous investor who bets on this happening. 'We look at US long bonds because we find that is the spread about which all other rates vary; it is the fulcrum of the markets,' said a director of one of the main clearing banks.

Even if the optimists about sterling rates, such as Midland Bank, are right, the scope for further falls in the UK is small compared with what has gone before. At best, it may be little more than a percentage point or so.

Yet at the other extreme, Royal Bank of Scotland is forecasting that base rates will peak at 10 per cent in the second quarter of 1996 - implying mortgage rates nearer 12 per cent. And it expects interest rates on five to 10-year investments to touch 10 per cent shortly before then. Barclays said yesterday that interest rates were close to their low point.

The marketing tactics of banks and building societies are another key factor. They are subsidising their fixed-rate offers at the expense of existing customers who mainly have variable mortgage rates.

Most fixed mortgages are on offer at less than a percentage point above the rate at which the funds are available to banks and building societies in the bond and swap markets. But existing variable mortgages are typically 2 to 2.5 percentage points above short-term money market rates, to which they are (very loosely) linked. The margin is well over double.

This could, of course, mean the lenders have more scope for lowering their variable rates to existing customers. On the other hand, the comparison does make fixed-rate mortgages look rather good value, since the lenders are willing to accept much lower profits to attract business.

One way of looking at it is to ask how much would have to be lopped off base rates for the variable rate paid by existing borrowers to fall as low as the fixed 6.99 per cent now available over five years. The answer is probably at least a full percentage point, which few believe will happen.

And some of the short-term fixed-rate deals of as low as 4.75 per cent over two years and 5.95 per cent over three are better rates than the Bank of England can borrow at.

Indeed, variable-rate mortgages are potentially so much more profitable over the next few years - even with the low-start options on offer - that some big societies are having second thoughts and encouraging their take-up again with seductive new offers.

Of course, fixed-rate deals are already enormously popular, accounting for a sixth of new mortgages in the spring of 1992 but passing 50 per cent by last autumn and probably up to more than 60 per cent by now.

All Britain is doing is coming into line with France, Sweden, Germany, Canada, the US and the Netherlands, where fixed- rate mortgages are the norm.

However, the overwhelming majority of existing mortgages are still floating rate, including those adjusted annually.

Some homeowners with variable- rate mortgages have been hanging back, remembering the experience of those who fixed their rates at 10 or 11 per cent a couple of years ago, and wondering whether they too will regret having moved too early.

Another deterrent is that lenders are tightening their conditions, particularly the penalties for early repayment, which were set too low in the early days of fixed mortgages. Those old loans are now being turned in for much cheaper ones. But with a 10-month interest penalty on many 10-year fixed deals, this may no longer be possible and is an incentive to stick to shorter periods.

Some of the very cheapest deals now extend the penalty period beyond the end of the fixed-rate contract, so a borrower is locked in to whatever floating rate the lender wishes to charge afterwards.

The biggest obstacle remains the cost of switching an existing mortgage to a fixed-rate one, which could be as much as pounds 1,000 with valuation and legal costs.

But there is an increasing number of cut-price transfer offers available. For example, John Charcol, the mortgage broker, is offering a fixed-rate, five-year mortgage at 6.99 per cent for a flat completion fee of pounds 250 - with no charge for valuation, solicitors' fees, land registry or local authority search. The mortgage is funded by Bank of Ireland. Some banks and societies offer similarly low switching costs to their variable-rate mortgage customers.

In normal times, such enthusiasm to lend would be a cautionary sign that still better deals are coming. But at the moment it may simply be a result of tough competition in the mortgage market, because house sales are still in the doldrums.

If the cost of switching to a fixed rate is low, it is hard to see the benefits of hanging on to a floating-rate mortgage.

Indeed, if the trend continues to accelerate, it could be the key factor prompting lenders to cut their profit margins on conventional mortgages by bringing down the rates to make them more attractive.

(Graphs omitted)