Gaining Your Interest- How Rate Rises Affect You

By Nick Funnell
Thursday 24th May 2007

Interest rates- yes, it’s that section of the news bulletin where you normally switch off or make a cup of tea. As the newsreader hands us over to the ‘Economics Editor’ (after all, this is important stuff and clearly needs an expert to be wheeled in), you know what you’re in for. Five minutes of drone about how a committee sitting somewhere in the Bank of England has decided to raise, lower or keep its interest rate (‘base rate’) the same.

Earlier this month (May 2007), this Monetary Policy Committee (MPC) decided to raise their interest rate a quarter of a percentage point to 5.5%, the highest level since 2001. This rate has been rising steadily from a low of 3.5% in September 2003, and many predict it could be edging towards 6% in the near future. You may have a fairly vague idea that higher rates will ‘cost you more’, but how? For most people, four main areas need to be considered:

Debt - both mortgage and other personal debt. How much of yours is variable (i.e. alters in line with the base rate), and how much is at a fixed rate?
Savings
Major purchases upcoming- consumer goods and/or holidays
Asset values - specifically, the price of your house

Your Mortgage - A Roof Over Your Head, or Millstone Round Your Neck?

There can be no doubt as to the most obvious headline effect of a rate rise; monthly repayments will go up for those with a variable mortgage rate. According to the Council of Mortgage Lenders (CML), the average outstanding mortgage is currently around £94,000, meaning that every quarter percent rise increases each monthly repayment by just under £20. Of course, with the UK house price boom continuing unabated, this figure may be of little relevance to most people- the average new mortgage approval nudged its way above £150,000 for the first time in Feb 07. You need to scale up (most likely) or down depending on the size of your amount outstanding.

With all the talk of interest rates moving upward, it’s no surprise that fixed-rate mortgages are more popular than ever. These will shield borrowers from the vagaries of the MPC’s monthly decisions, but only for a limited amount of time: 5-10 years is the most offered currently on the market. According to the CML, over half of all outstanding mortgages are now fixed rate, with 88% of all first-time buyers opting against variability.

Not taken the plunge into home ownership yet? Well there’s no need for those who rent to look smugly at mortgage borrowers when the latest rate rise is announced. The landlord could well have a mortgage on the place (especially with the recent growth in the buy-to-let market), and will be seeing their repayments rise. They can either just happily take this hit to their income, or pass it on to their tenants at the next rent review- what do you think is most likely?

Loans, Overdrafts and Cards

While secured mortgage lending, with around £1,100bn currently outstanding, is by far the UK’s largest sector of personal debt, other debt forms account for a hefty (and growing) £213bn. Base rate rises affect them as follows:

Personal Loans: most personal loans are at fixed rates once they are taken out, but of course new offers will get more expensive as the Bank of England rate rises. The market here is very competitive and good deals are certainly out there, though bear in mind that the advertised APR is only ‘typical’; the rate offered to you will depend on personal circumstances.
Overdrafts are always charged at variable rates, and will therefore be more expensive.
Credit Card debt is also always variable, though with rates 3 to 4 times more than base in any case, a 0.25% rise will barely be noticeable! The advice here is the same as always- get this debt paid off as quickly as possible.

Savings - the Brighter Side of the Rate Rise

Rises in interest rates aren’t bad news for everyone, of course- those with savings accounts should see the amount of interest they get paid rise along with the base rate. I emphasise ‘should’ as the banks have often been accused in the past of dragging their feet in passing rate rises on to their savers. For example, over 80% of savings account providers had yet to make a rate announcement more than a week after the latest rise. Shopping around and voting with your feet is the only way to deal with these laggards.

Incidentally, for those who have saved into a money purchase pension their whole working life, a base rate rise can mean that better annuity rates are available, leading to higher pension payments.

Hitting the High Street for Lower Prices

Retailers look upon rate rises, and their effect upon purchasing decisions, with dismay. Higher mortgage and debt repayments soak up customers’ disposable income, meaning less can be spent in their stores. Price cuts, special offers, two-for-one deals- often these are the only ways to tempt people to prise open their wallets and start ringing the tills. This is particularly the case for ‘big ticket’ items such as furniture and electrical goods, where the use of credit is commonplace. So, if you are in the market for a new plasma screen TV- shop around.

Further Afield- Exchange Rates and Holiday Costs

UK interest rate rises tend to increase the value of Sterling in relation to other major currencies such as the Dollar and the Euro. Those brash international currency traders see that they can earn a better rate of return in the UK, leading to an inward flow of ‘hot money’. You can benefit directly from this:

Holidays abroad will be cheaper. Most obviously you will see this at the bureau de change, but travel and accommodation savings should be sought as well.
Imported goods should go down in price. Retailers may pass a proportion of these savings on, but of course the brave new world of online shopping offers ample opportunities to try the importing game for yourself, buying goods denominated in cheap dollars or euros. Just watch out for those shipping charges!

Stop Watching Property Programmes! House Prices and the Psychology of Asymmetry

When the members of the MPC decide to raise interest rates, they do so with the idea of curbing inflation. As money becomes more expensive to borrow, there should be less of it around for people to spend, keeping prices steady. However, if there’s one thing in recent years that’s kept these bankers awake at night it’s the spectre of rampant inflation driven by rising asset values- specifically house prices .

The recent booming housing market has led many people to feel wealthier as their house price rises, and spend more. They do this even though their gains are only on paper while they still live in the house (although equity release schemes certainly add fuel to the fire). Raising interest rates, thereby making mortgages more expensive, should cool house price inflation. However, critics point out that the MPC is now powerless to prevent this juggernaut, the UK’s housing market addiction driven forward relentlessly by an unholy alliance of estate agents and TV property shows.

Worryingly, analysts now point to mounting evidence of ‘asymmetry’ in peoples’ wealth perception. In other words, higher spending levels due to house price rises are very sticky, and unlikely to be changed by downwards valuations (often seen as being only ‘temporary blip’). Further borrowing, via personal loans and credit cards, is sometimes used to bridge the gap between wealth perception and reality; thereby inflation remains unaffected and individuals are only more vulnerable to further rate rises.

So, the next time you hear an interest rate segment on the radio, maybe allow a couple of minutes for the implications to sink in before switching off.