Mortgage Guides

Beware of the 'cheap' tracker mortgage

By Seamour Rathore seamour.rathore@consumerchoices.co.uk

Stop! Is that tracker mortgage you’re about to sign up for, going to cost too much in the long-run?(9/7/09)

Tracker mortgages currently look like good value when considered side-by-side with fixed rate mortgages.

If the Bank of England base rate stays low for the next year or two, trackers will have proved to be a good choice. But if you’re attracted by low-rate trackers, you should consider the effect that possible base rate rises could have on your repayments in the future.

• 1. Historically low base rate
• 2. Historically high tracker mortgage margins
• 3. Mortgage lenders juggling their books
• 4. Mortgage affordability and making your payments
• 5. Tracker mortgage recommendations

A study by whole of market mortgage brokers Mortgageforce (www.mortgageforce.co.uk) found that one-third of people taking out a mortgage are now going for tracker mortgages, as fixed-rate mortgages are becoming increasingly expensive.

Katie Tucker, technical manager at Mortgageforce says: “Whilst a borrower’s choice between a fixed rate and a tracker is largely based on how they expect the bank rate to behave in the next few years, when the price difference between the two is this significant, it’s difficult to resist the cheaper one.”

As an example, one UK building society is marketing three-year fixed-rate mortgages at 5.28% and three-year trackers at 3.38%. Both of these are for remortgages for those with at least 25% equity in their home.

The tracker is, at first sight, a much better deal, but if the base rate goes up 2% from its current rate of 0.5%, then the new tracker rate will be 5.38% - already more expensive than the fixed-rate deal.

So, if you’re weighing up the pros and cons of fixed-rate mortgages and trackers, here are four principles you should take into account:

Back to the top

1. Historically low base rate

The Bank of England base rate has been 0.5% since March – an all-time low since records began in 1694. The low base rate means that if you look at trackers versus fixed-rate mortgages now, trackers look very attractive.

But in reality none of us know when the base rate may start to rise again, and if it does rise, how sharply it will go up. If you have a fixed-rate mortgage, you will be immune to base rate rises for the period of your fixed deal. But if you're on a tracker, your repayments will increase.

Also be aware that the rate you will be on after either your fixed or tracker period ends will be your lender’s standard variable rate (SVR). If the base rate has gone up in the meantime, so will your lender’s SVR, some of which are very low at the moment, due to the low base rate. For example Cheltenham & Gloucester’s current SVR is 2.5%, but it will go up in tandem with any base rate increases in the future.

Back to the top

2. Historically high tracker margins

The average margin for a tracker in July 2009 according to Moneyfacts.co.uk (www.moneyfacts.co.uk) is 3.27% over the current 0.5% base rate. That is a much bigger premium than people were paying prior to the credit crunch. The average tracker margin in July 2007, for example was just 0.48% over the base rate.

This enormous increase in the mortgage lenders' margins doesn't really reflect higher borrowing costs for them, as the current margin over their borrowing costs is massive too. Banks partly borrow from each other based on Libor (the London interbank offered rate). The current average tracker margin over Libor is 3.27%, in July 2007 it was 0.52%, according to Moneyfacts.co.uk.

There’s little you can do about the mortgage lenders charging us a premium to borrow. And it’s easy to forget about it, as the overall rate for trackers seems low. But that’s because the base rate is low. If the base rate goes up – you’ll feel the double whammy of a higher base rate and the chunky margin.

Back to the top

3. Mortgage lenders juggling their books

One of the key reasons that all mortgages have risen in cost compared to the pre-credit crunch era is that banks are being much more careful about the risks they take on. A vital part of that is ensuring they have a balance between fixed-rate and variable rate (ie tracker) mortgages on their books.

Mortgageforce’s Katie Tucker says: “The lenders have to keep their split between customers on fixed rates and tracker rates even, to mitigate the risk of their own wholesale costs rising; so they price their fixed and tracker deals to attract attention accordingly.”

Back to the top

4. Affordability and making your payments

If your mortgage already eats up a good amount of your monthly income, and the base rate starts to rise, a tracker could seriously eat into the rest of your household budget.

For example, repayments on a £150,000 mortgage on a tracker deal at 2.81% over the 0.5% base rate are £742.87 a month. But if the base rate rises to 3%, the monthly repayments will be £960.25. If the base rate hits 4%, the monthly repayments will escalate to £1,054.34*.

However if your mortgage is small and represents a more modest outgoing compared to your income, then any rising repayments may have less of an impact on your finances.

Source: Moneysupermarket.com

Back to the top

Tracker mortgage recommendations

Deciding whether to fix or track is a tricky decision at the moment. You should take time to examine your situation to ensure you make the right choice.

Things to consider include your view and the views of experts on where the bank rate is heading, your income and how big your repayments would need to become before you hit financial trouble, the term of the mortgage and the fixed/tracker deal period.

Two types of mortgages worth considering are a tracker with a capped rate, or a tracker which you can switch to a fixed-rate deal if rates start to rise. The latter is known as a drop-lock.

There are only a few of these on the market, but it's worth seeking them out. They could give you one possible solution to the conundrum of where interest rates are going in the next couple of years.

It's always wise to discuss your situation with an independent financial adviser and examine a good selection of deals on the market before making your choice.