Interest rates, mortgages and savings

While inflation is continuing to decline, it is crucial for the Bank of England (BOE) to avoid reacting too quickly or too slowly. The International Monetary Fund (IMF) recently suggested that the BOE should consider making cuts sooner rather than later, predicting a reduction in the base rate between 0.5% and 0.75% before the end of the year. Based on recent data and considering SONIA (Sterling Overnight Index Average) swap rates, which are a good indicator of the broader market, this could happen as early as July or August, with an additional cut towards the end of the year. SONIA is a benchmark interest rate for overnight unsecured transactions in the sterling market, reflecting the average interest rates that banks pay to borrow sterling overnight from other financial institutions. For fixed-rate mortgages, lenders use SONIA swap rates to hedge against interest rate risk. The rates at which lenders can hedge impact the fixed rates they offer to borrowers, meaning higher SONIA swap rates can lead to higher fixed mortgage rates.

With the upcoming general election, there are potential impacts on this timeline. The election could either facilitate or delay these potential rate reductions. It will be interesting to see what the parties propose regarding the BOE, mortgage rates, the cost of living, and what support they plan, if any, for first-time buyers and homeowners. These factors could significantly stimulate or stall the market post the July election.

Interest rate increases are not much different from petrol pump prices – fast to go up and slow to come down! We think interest rates will start to reduce slowly this Autumn but if anyone thinks they will go down as low as 0.5%, think again! Plan on 3% being the lowest they will go. Plan also on returning to a more normal behavioural pattern where interest rates are used as a tool to combat inflation.

We’ve become accustomed to unusually low mortgage rates way before the mini-budget, which significantly fuelled the mortgage market, especially during the COVID-19 pandemic, when rates dropped as low as 0.89%. We all knew these rates couldn't last forever, but several unforeseen factors came into play. The war in Ukraine led to a cost-of-living crisis, pushing inflation to record highs. Following that, the Liz Truss and Kwasi Kwarteng mini budget was poorly received by the wider markets, causing mortgage rates to skyrocket overnight as lenders reacted by pulling their rates, and effectively shutting shop.

We must remember that as inflation rises, it's natural for mortgage rates to increase gradually. However, this process was accelerated dramatically. Was this rapid rise beneficial? Potentially, if not for the mini-budget, mortgage rates might still be climbing. Thankfully, rates are now slowly dropping, in line with the Bank of England's predictions, aiming for a return to some sort of normal by 2025/26.

The impact on mortgage payments has been significant, particularly for those coming out of fixed deals where rates have doubled. For those looking to enter the market, affordability has tightened, making a larger deposit crucial. Lenders have responded by launching 100% mortgages for renters and lowering stress test rates for first-time buyers who lock in for longer terms.

Interestingly, while overall property prices dipped, Scotland fared better. Cities like Glasgow, Edinburgh, and the coastal towns in East Lothian still experienced a general increase in house prices.

Obviously, money invested in bank deposits will be vulnerable to inflation; otherwise, its value remains the same, (Unless we have another Northern Rock debacle such as we had in 2008.) The same is not true for the value of money invested in the stock market e.g. bonds and equities: their value is likely to fall. This is for a number of reasons. In the case of equities – stocks & shares – it is because investors worry that a rise in interest rates means lower profits and lower profits means lower dividends for shareholders. You might think that rising interest rates means rising bond values, but in fact it's the opposite. This is because when interest rates go up, the price of the bonds you already hold will go down. Why? Because the capital value of the bond you hold will have to fall to compete with new bonds being issued at a higher coupon (interest rate.) In the months from December 2021 to August 2023, we saw interest rates climb from 0.5% to 5.5%; those of us holding bonds during this period saw the capital value fall - in some cases quite sharply. For example, a corporate bond fund we like very much (Royal London Sterling Extra Yield managed by Eric Holt) fell during this period by nearly 14%). Now, as inflation has fallen from its peak of 11% to just 2%, the direction of interest rates is likely to be south, with the result that the value of the bonds you hold will likely increase. This is an over-simplified explanation of bond behaviour - it is more complicated than that when you factor in what we call duration (the length of time till repayment/maturity) – the shorter the duration, the less vulnerable you are to price fluctuations.

Regardless of the outcome of the forthcoming General Election, it is commonly thought that interest rates will start to decline this Autumn. Many companies borrow money to fund investment in Research & Development and Fixed Assets. Lower costs of borrowings is likely to result in higher company profits, leading in turn to a better return for equity investors. Bond holders are also likely to see their valuations increase. One more point worth making. With markets becoming more positive, the gap between Net Asset Value (NAV) and share price for Investment Trusts - a favourite investment vehicle of ours – is likely to close. That is, investors have good prospects for picking up investments in these funds at a discount, i.e. cheaply!

In summary, we are optimistic about prospects for savers for the next 3-5 years. As for where interest rates will “land”, we think 3% is likely. What is certain is that we will not see interest rates at the rock bottom rates of 0.5% for a very long time to come – so plan on about 3% and for quite a long time.

If we continue on the current path without further disruptions, the expectation is that the UK market will stabilise, with the BOE Base Rate settling at around 3.5% to 3.75% by the end of 2025 or early 2026. Consequently, mortgage rates are likely to reduce broadly in line with these adjustments. However, it's important to remember that we won't see mortgage rates sub 2% again; instead, they are likely to hover around the 3.25% + mark.

Saving for retirement is best started as early as possible; the power of compounding investment returns over time should not be underestimated, Pensions & ISAs are both tax protected vehicles, but there is an added tax advantage of making pension contributions – you get income tax relief on pension contributions you make; and if you are trading through a company, the company can make pension contributions on your behalf and get corporation tax relief. ISA subscriptions – maximum £20,000 p.a - do not qualify for tax relief. With this - in mind, we would recommend you continue to save into your Pension if you can; but perhaps pause the ISA contribution with a view to reinstating it as soon as is affordable. (Post Script – Pension rules and regs are complicated – do consult your qualified IFA before you act and make sure you don’t fall into any potholes.)

I would recommend starting the remortgage process now, as it typically takes around 2 to 3 months. If switching providers could save you money, it's worth beginning the process early. By speaking with an independent mortgage broker, you can review not only what your current provider offers but also compare it to the wider market. This can help you identify potential savings and provide a clear picture of your options making the decision process easy and if you have all the right information to hand can take minutes. 

Unfortunately, we are all facing increases in our mortgage payments. However, it's important to remember that rates have dropped from over 6.5%. Speak with a mortgage broker to understand your future payments and we will support you to choose the right product for your short, medium, and long-term plans.

Where possible, it's advisable to maintain your mortgage payments at the current level. Long-term financial advice often includes repaying debts first, starting with those carrying the highest interest rates, which for most people is their mortgage. By getting good advice and planning for the future, you can potentially align your mortgage with the Bank of England's predictions. If these predictions hold true, you may be able to increase your savings sooner.

Each person's situation is unique, so personalised advice is crucial. Consulting a mortgage broker and an Independent Financial Advisor can help tailor the strategy for your specific circumstances.

We are tempted to say, “how long is a piece of string”?! This is a question about choices and what we call “risk appetite”. On the one hand, cut debt: on the other hand, maintain the level of debt and hope that investment returns outweigh the cost of the mortgage. Because every customer is different (circumstances, time horizon etc) it really is important to talk to an experienced and qualified IFA with a view to making an informed decision. In summary, there is no “one rule fits all” answer - each case has to be considered on its own merits etc.

Paying off part of your mortgage can save on interest, as reducing the loan amount decreases the total interest paid over the loan's life. It provides a guaranteed return equivalent to your mortgage interest rate, which is risk-free compared to the stock market. Reducing debt can also enhance your financial security and improve cash flow. There is a good argument in partially repaying your mortgage as this offers a balanced approach, giving some benefits of debt reduction while retaining funds for investment. This option provides flexibility by reducing the mortgage balance and keeping liquidity for other opportunities or emergencies. The impact on monthly mortgage payments won’t be seen until you are able to negotiate your mortgage term, at say the end of the fixed rate. This still offers a middle ground between reducing debt and maintaining investment potential.

You will need to consider your short-term and long-term financial goals; if paying off the mortgage aligns with these goals and provides peace of mind, it might be worth prioritising. Thinking about your risk tolerance; if you're risk-averse, reducing debt might be preferable, while if you're comfortable with investment risk, you might prefer potential higher returns from investing. Consider your need for liquidity; if you anticipate needing access to funds soon, investing in assets like ISAs might be better than tying up money in a mortgage.

When deciding whether to use your savings to reduce the borrowing requirement for your house purchase, there are several factors to consider:

1. As interest rates are higher than in previous years, borrowing the full £175,000 will result in higher monthly repayments and overall interest costs. Reducing the amount, you need to borrow can help reduce these costs.
2. By borrowing less, your monthly mortgage payments will be lower, freeing up cash for other expenses or savings. Additionally, less borrowing means you'll pay less interest over the life of the mortgage. A lower borrowing amount relative to the property's value can improve your loan-to-value (LTV) ratio, potentially qualifying you for better mortgage rates and terms.
3. While using your savings to reduce the mortgage amount can be beneficial, it's also important to retain some savings for emergencies. Keeping a portion of your savings accessible can provide a financial cushion for emergencies or unexpected expenses. Balancing the use of savings and borrowing is crucial to ensure you maintain financial security.

We agree with the sentiments expressed by Rettie. Other than that, our answer to Scenario 1 can be applied to this scenario – refer the question to your IFA and tease out an appropriate answer. (We like Rettie’s idea of an emergency cash reserve – if possible, it should equal about 6 months of day to day living costs.)