Understanding interest rates and inflation

Clearly, the price of household goods and services has increased significantly over the last year. This is due to inflation – the term used to describe rising prices and a decline in the purchasing power of money. The Bank of England controls inflation using interest rates, which reflects the amount you are charged to borrow money.

With inflation having risen steadily over the last year, the Bank of England has continued to increase its base interest rate incrementally, most recently to 4%, in an effort to mitigate against inflation. Following last September’s mini-Budget in particular, the interest paid on loans increased significantly. This coincided with significant rises in the cost of day-to-day essentials and energy bills which further reduced households’ spending power.

Yet despite the base rate rising, at the end of last year we began to see the average cost of fixed rate mortgages fall, in a trend that has continued in the opening months of 2023.

Indeed, with lenders providing increasingly competitive rates the market outlook for this year is looking increasingly positive, with large numbers of mortgage products returning to market. So, why the disparity between mortgage rates and the base rate? We take a look in this article.

Introducing swap rates

The reason mortgage rates have been able to come down, even in the face of base rate increases, is largely thanks to swap rates. These are the rates lenders pay to banks to borrow money for a set period of time, and are used by lenders to calculate mortgage product pricing.

Since swap rates are determined by what the financial markets predict the base rate to be in the future, current swap rates have already priced in future changes, allowing mortgage pricing to come down as lenders look longer term. As a result, mortgage product pricing could continue to decrease, easing affordability pressures, even if the base rate continues to rise by small margins throughout 2023.

Why else are mortgage rates coming down despite base rate increases?

It’s clear that confidence is fast returning, and the mortgage market has continued to stabilise throughout the first few months of this year. Mortgage products are returning to market, with the latest Moneyfacts data revealing a rise in product choice with over 4,000 options for the first time since August 2022.

Banks and Building Societies are eager to lend and generate a busy mortgage application pipeline to sustain themselves throughout the year after a relatively quiet period during the last quarter of 2022.

As a result, lenders have engaged in positive price wars, vying for business and driving mortgage rates down even further, with Moneyfacts showing rates for two- and five- year fixed rates falling for a third consecutive month. Furthermore, Moneyfacts shows recent rates on five-year fixed rate products as low as 4.59% on a 90% Loan To Value (LTV) mortgage in February, in comparison to the average rate on all LTVs standing at 5.63% in January 2023.  

Although rates are higher than before the mini-Budget and the pandemic, it’s also important to keep in mind that UK interest rates were previously marked by historic lows, standing at their lowest level in recorded history in March 2020 at 0.10%.

Furthermore, the average base rate over the last 25 years stands at 3.8%, with today’s rate sitting marginally higher. Therefore, rates are reaching a new normal, and the market is stabilising in line with longer term trends.

What does this mean for my mortgage?

For existing homeowners on tracker or variable mortgages, monthly repayments will increase or decrease in line with the interest rate changes. Borrowers with a fixed rate whose mortgages are expiring will be able to choose from a wider range of products at comparatively lower rates than in Q4 2022, albeit at higher rates than pre-pandemic.

You should seek independent mortgage advice on the benefits of fixing now at current rates, or choosing a variable or tracker mortgage whilst keeping in mind that rates could rise as well as fall in the coming months.

Advice will be crucial if you’re looking to navigate the ever-changing product and rate landscape, and will ensure that they are able to source the most affordable and appropriate mortgage to suit your individual needs.

This information was contributed to by our friends at LSL Financial Services. LSL is one of the largest providers of services to mortgage intermediaries, specialist mortgage and protection advice to estate agency and new build customers and valuation services to the UK’s biggest mortgage lenders.