MoneyGuide

When will interest rates go up, and what will the consequences be?

By Seamour Rathore seamour@consumerchoices.co.uk

Historically low interest rates mean lower mortgage repayments, but poor savings returns. We look at what will happen when rates start to rise again. (3/9/2009)

All-time low interest rates have defined 2009 and have benefited anyone with a variable rate mortgage. But such low interest rates have been a disaster for people who rely on the income from savings.

So, why are interest rates so low and when can we expect them to rise?

Rate cut history

The Bank of England cut rates aggressively to stimulate the economy and avoid a recession.

It started to cut interest rates in October 2008, when it pushed them down from 5% to 4.5%. Over the following six months it pursued a policy of cutting aggressively until rates reached 0.5% in March this year.

Quantitative easing was designed to make it easier for banks to lend to creditworthy people and companies

But ultimately the UK was unable to avoid slipping into recession.

The rate has now been 0.5% for five months and the Bank has also attempted to kick-start the UK economy using a policy of quantitative easing. This was designed to make it easier for banks to lend to creditworthy individuals and companies.

When will rates go up?

The base rate is used by the Bank of England to control inflation. In recent months, inflation has not been considered a threat and so the Bank was able to cut rates.

However, several factors will determine when and how sharply rates will go up in the future, including the following:

The consumer prices index (CPI) and retail prices index (RPI) both give a measure of inflation on a monthly basis. However, neither figure is turning out to be as low as expected on a monthly basis. If inflation does rise dramatically, the base rate may too need to be swiftly increased
Quantitative easing – The Bank of England’s programme of quantitative easing swaps high street banks’ assets, such as bonds, for cash, so that the banks would have the readies to lend to creditworthy individuals and businesses.

But so far the banks have been sitting on this cash, rather than lending it, so the effects of quantitative easing in the real economy have not yet been seen. When this money does begin to flow into the real economy, this could result in a rise in inflation and thus the base rate may be increased.

In addition other factors, such as where policy makers and experts believe rates are going, are also important.

A poll of economists by news agency Reuters in early August showed that they expected the base rate to remain at 0.5% until around May 2010. They also said they would expect rates to move up to around 1.25% by the end of 2010. At 1.25%, rates would still be historically low.
In March 2009 a member of the Bank of England, Spencer Dale, said that if it was needed, due to rising inflation, the Bank wouldn’t hesitate to put up interest rates as sharply as it cut them in 2008/2009.
In August, the Bank of England decided to expand its programme of quantitative easing (QE) by a further £50billion (making the overall total £175billion). Mervyn King, the governor of the Bank of England was in favour of increasing QE to £200billion in total. These factors both suggest that the Bank is not worried about spiralling inflation at the moment.

Further into the future, and it’s anyone’s guess what may happen. At one extreme, some experts believe that we are in for many years of low inflation and low interest rates – perhaps as far out as 2013.

At the other end of the scale, another set of experts believe quantitative easing coupled with massive public debt will mean that interest rates will have to rise sharply.

What are consequences of higher interest rates?

Mortgages: If the base rate rises, anyone on a variable rate mortgage, such as a tracker or their lenders standard variable rate (SVR), will find their monthly repayments will go up.

If you want to see what effect rising interest rates would have on your mortgage repayments, use our mortgage calculator.

For mortgage holders who feel that rising rates are their biggest concern, one option is to switch to a fixed-rate mortgage – which will give them certainty about their mortgage payments for a given term.

However, banks are putting a high premium on fixed-rate mortgages - they are historically expensive. So borrowers will have to think this decision through very carefully – perhaps with the help of an independent financial adviser.

It is possible that when interest rates start to rise, it could push more people in arrears in their mortgages, if they find they are unable to meet their monthly mortgage repayments.

Unemployment, one of the major reasons people fall into arrears, is at its highest level in 14 years, and businesses continue to shed workers to cope with the recession. The Council of Mortgage Lenders has estimated that there will be 65,000 home repossessions in 2009.

Savings: Savings rates initially fell along with the Bank of England base rate.

Towards the middle of 2009, though, lenders including several building societies, increased their savings rates in order to attract more savers. This was designed to increase the money they had on deposit, so that they could ultimately do more lending to fund mortgages and businesses. Lending money out brings in revenue for banks

However, for the most part, savings rates – particularly for ISAs – are still low. Therefore anyone with savings should discuss their full financial situation with an independent adviser, to make the best of the returns available without taking on unnecessary risk.