View from City Road: Lenders need to be flexible over fixed rates

Many people who expected a Labour election victory took out fixed rate mortgages at 11.5 per cent in 1991, and now find it hard to hail them as a great innovation in personal finance. Though fixed rates bring peace of mind when rates go up, they are also extremely irritating when rates fall further than expected.

Yesterday Barclays stepped up the competition in the fixed rate market with a new seven-year mortgage at 8.5 per cent, which it claimed was the cheapest 'millennium mortgage' on offer. It expires in January 2000, and should take borrowers through to the other side of the next housing market cycle. Those with nearer horizons can opt for 7.99 per cent for five years or 6.99 per cent for two years.

As gambles on interest rates go, these are not bad levels. Even if there is another cut in bank base rates, there is a fair chance that only a part will be passed on in mortgage rates. Building societies are facing stiff competition from National Savings and other institutions. Moreover, the interest rates over two to five years may move even less, and they determine the fixed rates.

This message is certainly getting across. Up to 80 per cent of Barclays' new mortgages are at fixed interest, which has grown to pounds 3bn of the group's pounds 10bn home loan book. By last summer, surveys showed that fixed rates accounted for more than a quarter of the mortgage market, and the proportion is bound to have increased since then as interest rates have come down.

Fixed rate mortgages are not unlike a bond investment, in that timing is all: lock into the interest rate cycle at the right moment and there is a certain gain compared with what the costs would otherwise have been.

But getting the timing right is notoriously difficult. It may seem obvious now that we are at or near the bottom of the interest rate cycle and that average rates over the next seven years will be nearer 9 per cent than 7 per cent. The yield to maturity on a gilt-edge stock maturing in 2000 is around 7.5 per cent, so a 1-point margin for Barclays does not seem extortionate or out of line with market perceptions.

But there is nothing, as the forecaster said, so uncertain as the future. Will that 8.5 per cent mortgage soon be as irritating as that once fabulous 11.5 per cent deal, marketed as far below the long run average of mortgage rates? The professionals have a hard enough time getting bond and bill markets right, let alone the average home buyer.

The answer may be to worry less about rates and more about flexibility. Most fixed rate mortgages lock borrowers in for long periods with heavy cancellation penalties - seven months' interest in the first two years of the Barclays mortgage, reducing to three months in the final three years.

In America, where the fixed rate mortgage is the norm - currently 85 per cent of lending - there is an extra ingredient in the market. James Johnson, head of Fannie Mae, the world's largest mortgage corporation, says business has been booming since US interest rates went into low single figures. One of the main reasons was a wave of refinancings of old fixed rate mortgages taken out at higher levels.

The ability to trade in an old mortgage at reasonable cost is clearly vital to the operation of the market. If the fixed rate mortgage market is to become a permanent feature of the UK, rather than a passing phenomenon while interest rates are low, then competition needs to focus far more on the cancellation terms and less on the odd half a point off the rate.