How to avoid a mortgage rate hike shock

By Nic Cicutti
Planning can help avoid potential pitfalls

FOR HUNDREDS of thousands of homebuyers in Scotland, the latest base rate rise last month was an unwelcome surprise and will lead to higher variable mortgage increases of 0.25%. But for many borrowers coming to the end of their fixed-rate deals, home loan costs could soar far higher than that.

Lenders call the phenomenon "payment shock" and warn that the problem is likely to intensify, especially for those on two and three-year deals maturing in the coming months.

The exact number is not known. However, Larry Banda, head of mortgages at Nationwide Building Society, says he is expecting to see a significant upward spike this summer.

advertisementBanda says: "The period between July, August and September 2005 was a very busy time for fixed-rate deals. We are expecting a strong' August compared to last year, about 40% higher."

The problem stems from the fact that up to 60% of new borrowers are now taking out fixed-rate deals. Their mortgages are pegged at a certain level, on average for between two and three years. Inevitably, their deals eventually come to an end - and suddenly they find that the cost of their home loans rise not just by 0.25% but by anything up to 2%.

For a borrower with a mortgage of £100,000, moving from a typical two-year fixed rate of 5.5% to today's commonly applied variable rate of 7.5% means finding an extra £125 a month, or £1500 a year.

A basic-rate taxpayer will need to find an extra £2000 from his or her pre-tax income to pay for that increase, while a higher-rate taxpayer would have to allocate almost £2400 more.

Recent research by the Council of Mortgage Lenders, the industry trade body, suggests that it will inevitably force up the numbers of people across the UK who are over three months in arrears by about 25%, to 130,000 cases.

A CML spokeswoman says: "One of the reasons why we have pushed up some of our arrears forecasts is that we think there will be quite a high proportion of people coming back into the market at a higher rate.

"What we are trying to do is assess the trade-off between the intensity of payment shock and the volume of people involved."

Despite the looming problem, lenders are very keen to reassure the public that things are not as bad as they might seem.

Banda says Nationwide and other lenders make future "affordability calculations" when deciding how much they will offer an individual. These are based not only on current earnings and outgoings but also calculations of what might happen to a borrower if interests rise by a substantial amount.

He adds: "What also needs to be taken into account is the fact that most salaries will have increased between first taking out the mortgage and the first time they face rate increases."

For those who do face a sharp rise at the end of a fixed period, lenders advise getting in touch long before the old deal ends. A spokesman at Bank of Scotland says: "The best thing to do is find out what new rates are available.

"If your deal is coming to an end, then you can still book the funds in advance. Whatever you do, don't wait until the last possible moment." He points to recent fixed-rate price movements, where old deals are being replaced by ones that are up to 0.4 percentage points higher.

Nationwide, meanwhile, not only writes to all its customers three months in advance of a deal ending, it is also willing to let them switch to a new one ahead of the existing one ending - if that is what they wish.

Larry Banda says the evidence suggests more and more borrowers are now opting for longer fixed-term deals of up to five years, to help avoid future payment shocks: "People are saying, When you look at five-year rates, there's not as big a difference between them and two-year deals.' "My personal view is also that some customers need to understand not only the monthly cost of a mortgage, but also the impact of reservation fees over the lifetime of a mortgage.

"Over time, they all add up, especially if they are added to the total cost of the loan."

Some borrowers may be tempted to move their loans from repayment to interest-only.

However, the CML spokeswoman says that may be a mistake: "To some extent it is probably better to do that than to fall into arrears. But the decision should be seen as transitional, and certainly not a permanent one.

"If the choice is between that and cutting other areas of household expenditure, cutting back is probably better."

Robin Amlot, senior editor at Moneyextra, a price comparison website, points out that switching financial products - including mortgages, life insurance, savings and loans - to a better deal could save massive amounts.

He adds: "The savings between the best and worst products could mean an increase, in after-tax income, that is the equivalent of an increase in gross earnings for a basic rate taxpayer of almost £7000 a year."