Bank of England Interest Rate and its Effect on Mortgage Interest Rates

Historically (since 1694) the Bank of England (BoE) Interest Rate never fell below 2%, and between 1694 and the start of 2009, the long term average rate has been 6%. The recent 0.5% cuts in the BoE interest rate over the last year or so have taken the Bank of England Interest Rate down to a historically low 0.5%, well below the long term average. The graph below shows the BoE Interest Rate over the last 30 years. This is the lowest Bank of England interest rate since records in 1694 began. The recent fall in the BoE interest rate should give further relief to some mortgage borrowers, even though not all lenders are passing on these interest rate falls to all customers.

In theory the interest rate cut should make it easier to afford the interest payments for a mortgage compared to the 1980's and 1990's, but due to the current credit crunch, many banks and building societies have been choosing to hold their lending rates in the face of recent BoE interest rate cuts, simply to try rebalance their accounts. The key interest rate which determines how much of this the banks will pass on, is LIBOR (London Inter Bank Offered Rate). The LIBOR rate is always above the BoE rate and has been as much as 2% higher in recent times. Although some of the large lending institutes have announced that they will pass on recent rate cuts to customers, it still doesn't mean that the credit crunch will end any time soon.

Back in the early 1980's and early 1990's when interest rates went around 12% to 15% we also had high inflation, so a mortgage loan was effectively shrinking faster in terms of moneys purchasing power. At the moment debt is only shrinking at around 3% per year due to inflation. Inflation is beginning to look like it has peaked for the moment and has fallen as lower oil and food prices have fed through to the figures over the last few months.

Also, as first time buyers will be aware, having low interest rates which makes interest easier to pay, isn't much help when the property prices are so high in the first place. The interest per month may be a relatively small proportion of mortgage value, but high property prices mean large mortgages which means large monthly payments. The problem is that property prices rose faster than wages in the early part of the 'noughties', meaning that although the interest rate for a mortgage loan is relatively low, the amount of loan needed to purchase an average property has shot up without the average persons 'ability to pay' increasing by the same proportion. 

The property price decrease of the last year have helped to make property more affordable for the first time buyer, but only if those first time buyers can hang on to their jobs, and if money is available to lend. Recently we had the first reported property price rises in the last couple of years. Some commentators believe this signals that the property slump is now over. Here at Better-Mortgages we are not so sure. It is a feature of most market cycles that prices never go up or down in a straight line, so we could be seeing the start of a property rally which may fizzle out in 6 months or so, when prices will begin to move down again.

Why may this happen? Well, there are some people who have been desperate to sell their properties in a poor sellers market. They will take advantage of any upturn to try sell their properties, thus increasing supply over the next few months. If buyers can afford it (questionable in the current recession) they may commit themselves, and prices could be marked up. If not then a glut of properties my nip any recovery in the bud and send prices lower. We believe the latter is more likely, with a second downward leg of the price fall coming into action. Once this is over then we have a much more likely base for prices to move up in a sustainable manner.

Now, just because the BoE have lowered base rates for the eighth time in just over a year doesn't mean to say that inflation is not still a threat. Although the BoE has stated that core inflation is drifting down again that doesn't necessarily mean that its dead and buried. While the old RPI measure (including the cost of mortgage interest) went down to 0% in March, the newer CPI measure is still 0.5% over the Governments inflation target, implying that the price of most things apart from mortgage interest payments is still going up at a faster rate than the Government would like.

The credit crunch, which has bitten hard on the UK economy, has already drives us into recession (which is fairly common during a typical 4-5 year business cycle), along with many European trading partners, the USA and the Rest of the World. If the recession is deep and long it could turn into a much more painful and longer lasting depression similar to the Japanese experience since the early 1990's. The announced measures of the Government bailout of UK banks may have gone some way to reduce the likelihood of depression, but recession will be with us for at least another 18 months in our opinion.

Oil prices have been much higher than they are today, and energy prices have also increased dramatically over the last 6 to 9 months and have yet to reflect the recent fall in the oil price. There is still the potential geo-political effects of Russia and the Middle East to consider, both of which control a huge portion of our current raw energy imports, and with both political and economic areas open to further deteriorate, especially with Russia flexing its military might again, and causing issues over energy supply to spread across Europe, which are caused by politics rather than supply and demand. Again we've managed to reach the warmer spring time without any major energy shortage in Western Europe.

The UK property market has slowed dramatically over the last year with property values in the UK drifting lower on a year to year basis. While this is good for 'first time' buyers, bringing the price of property more into their reach, the credit crunch means that lenders have stopped offering the 100% plus deals to anyone, so a first time buyer is going to have to come up with at least 5 - 10% cash deposit. For those people with credit issues, the lenders have tightened their lending criteria so much that most people with adverse credit histories would be lucky to be offered a loan of much more than 70% of the property price. By definition, people who are finding it difficult to control their credit usage, are not likely to be able to come up with 30% of a property price as a deposit, so in effect these people are excluded from getting onto the property ladder, and those who already own a property possibly don't have 30% equity in their property (whose value is falling anyway) to allow them to re-mortgage to a better rate.

We still have the situation where banks are refusing to lend money to each other because they don't know who might go bust next. It will take a further round of financial reporting to be comfortable that all bank losses have been reported, allowing banks to be properly analysed as to the robustness of their businesses. Along with the Government support offer to banks, confidence in inter bank lending should return at that stage.

In the last year we have fairly rapidly become a nation of bank owners, with Northern Rock and Bradford & Bingley being under direct control of the Government, and the substantial Government share ownership in many other banks. If the Government (i.e. you and me, the taxpayers) promise to ensure no other bank goes bust, then in theory the banks no longer have to worry about each other going bust and so should be able to start lending to each other in confidence again. However lets not forget these banks are still mainly commercial companies, so they are going to use this Government investment in whatever way the board of Directors see fit (i.e rebuilding their balance sheets). This may not match what the Government would like them to do with the funding. We can still see the 'old thinking' still at work as the major banks (now largely responsible to the taxpayer as major shareholders) still having to be cajoled and bullied into passing on the Bank of England interest rate cuts. Although we have not heard of many further financial institute failures around the world, the occasional one still crops up in the news, so until we've had reporting from all banks, revealing all write-downs, and had 6 months of no institutional failure, only then could we be reasonably certain that the current crisis is over. In this new environment all lenders will have to revert to more traditional, less risky ways of raising money for lending purposes - customer saving, long term bond issues, raising money from existing investors (if they have the cheek to ask) and so on. Banks will no longer be the racy growth investments that they have been in the last decade or so, and maybe that's not a bad thing.

What it definitely means for mortgage customers is that banks are tightening their lending criteria to avoid taking on any more risk until the current risks have been properly determined. There are no longer any 100% + residential mortgages, or development funding in the commercial sector, available in the market place, and although this will create difficulties for some borrowers in the short term, it has to be a good thing for the security and confidence in the financial economy to get back to a more realistic assessment of risk However it does mean that the traditional links between the BoE interest rate and a lenders base rate has temporarily broken down as indicated by the wide spread between the Bank of England interest rate and the London Inter Bank Overnight Rate (LIBOR). Don't expect lenders to pass on full interest rate cuts to borrowers in the short term, but do expect interest rate cuts to savers to flow through pretty quickly.

So to recap, property is down, the stock market is down, lending rates are drifting lower, lending criteria has tightened, the banks still don't trust each other, the flow of cash around the monetary system has ground to a halt as a result, and the Government is having to buy banks whole or in part in order to stop the rot.

As the old Chinese curse goes 'May you live in interesting times'. It will probably take another few months for it to become clear whether the Government bail outs, both here in the UK and around the world, have worked and for the cost of the credit crunch to become clear. Until then obtaining mortgages and loans will be difficult for everyone but especially those people with credit problems. As the other old saying goes 'You have to cut your cloth to fit' meaning we'll all have to look at ways of dealing with whatever this down turn throws at us.

As a final crumb of hope though, while these financial shocks come along every now and again to spoil the party, they usually don't last forever (no mater how bad it feels when you're in the middle of it), and they give us an opportunity to learn to run our affairs in a better way, if we choose to take notice. Lets hope the Government, the financial regulators, and the banking system and consumers learn from this current situation. We also heard in early February that the Halifax housing index had actually gone up in the previous month, which was the first rise in 11 months. However, markets never fall in a straight line, so while we might see a little bit of house appreciation over the next month or two, it maybe only a rally in a longer fall, with further house price reductions to come.