The Bank of England didn't spring any surprises last week after it left interest rates on hold at 4%. Indeed, one corporate scandal after another and the stockmarkets fluctuating widely may delay the next rate rise until 2003. As a result, lenders are starting to relax their fixed rate pricing, meaning there's plenty of opportunities for your clients to cash in.
But is it better to fix or cap mortgage rates?
Fixing repayment rates against costly shifts in interest rates is a classic lending technique. The solid, dependable fixed rate book is never far behind a lender's showroom display of flexible discounts, all-in-ones and trackers – and the fixed rate label is familiar even among people who have never taken a mortgage.
For many, opting for the longer-term security of fixed monthly repayments over the immediate cash thrill of a discount is the more sensible option.
Fixed rate mortgages offer a good deal for many customers.
Capped rate mortgages are more expensive than fixed but they offer a high repayment watermark in the same way as a fixed rate and, more importantly, will pass on the benefits of interest rate cuts in full now that many lenders have thrown out the associated 'collar'.
David Hollingworth, mortgage specialist at London & Country, says if fixed and capped rates were priced the same, he'd choose capped rates every time.
“If rates fall the benefit is passed on,” he says. “But, unfortunately, capped rates are usually more expensive than fixed.”
If follows that taking a straightforward capped mortgage is only worth it if a borrower thinks rates are likely to come down. “If rates are only likely to rise, what's the point of taking a straightforward cap over a cheaper fix? You would effectively be fixing your money at a slightly higher rate,” says Hollingworth.
Two weeks ago, the slightest hint of a rate rise might have ended the fixed versus capped debate. Economists and money markets alike were gloomily awaiting the end of the rate cut bonanza, which has seen interest rates held at a 38-year low of 4% since November 2001. Personal finance columns were urging borrowers to fix their mortgage repayments fast, even though lenders were generally agreed that the best of the rates had already gone by.
But then WorldCom, combined with other financial scandals, engineered a stockmarket environment that made the Bank of England reluctant to change the low interest rate protection for fear the economy would topple over. And, as luck would have it, we are living through the lowest UK inflation figures on record, meaning that the consumer-spending boom is still affordable.
Ray Boulger, senior technical manager at Charcol, says it's looking increasingly unlikely that we'll see a rate rise this year.
“If equity markets remain at these sorts of levels I think we'll soon be talking about whether we're going to see another rate cut rather than a rate rise,” he says.
If a further rate cut becomes a serious possibility, the argument for capping money rather than fixing will become stronger.
But is it worth paying the extra? Kevin Morgan, managing director of Hertfordshire-based EZI UK, says that the choice between capped and fixed depends very much on the client's attitude towards risk.
“If they feel rates may fall but want to know they won't pay above a certain ceiling come what may, paying a premium for a capped rate is fine,” he says.
“It is a good time to buy some security at knock-down prices but it's also one of the best times to service your mortgage at a super-low rate and put the savings towards that consumer boom we're all supporting.”
As Mortgage Strategy went to press the best three-year discount out there is Norwich & Peterborough's 3.44%. The most competitive fixed rate deal is N&P's 4.69%, while the best straightforward cap trails in at GMAC-RFC's 5.29%.
Simon Bucknell, business development director of Square Mile Mortgage Finance, says the London-based brokerage is receiving more enquiries on fixed and capped rates, although not many people are taking them up.
“The margin between a fix and a discount is a good 1% at the moment and people are going with the cheaper money,” he says.
CML figures show fixed rate sales in steady decline this year. After rising to 39% of the total number of loans made in January 2002, by April, fixed rate products only accounted for 31% of mortgage sales – despite the average fixed rate dropping from 5.19% to 5.12% over the same period.
Meanwhile, numbers of variable rate loans grew from 104,000 in January to 147,000 in April, even though the average repayment rate rose from 4.39% to 4.56%.
Part of the decline in fixed rate popularity is due to a public growing complacent about low interest rates. Minutes from July's rate-setting meeting of the Monetary Policy Committee shows that Bank of England bosses are nervous that “the latest surge in house prices might reflect a belief by some borrowers that the reduction in interest rates from 6% to 4% over the past year would be permanent”.
Evidently, 4% interest rates cannot continue indefinitely. John King, product and marketing manager at Coventry Building Society, believes that the UK is at the bottom of the rate cycle.
“Rising house prices equals higher income multiples – all of which increases the risks of borrowers being overstretched by an interest rate rise if they take discount or tracker products,” he says.
Meanwhile, Nick Hale, sales director at Cheltenham & Gloucester, says that the gulf between fixed or capped rate and discount pricing is such there is no need for borrowers to rush to secure their repayments. “If rates increase, we're likely to see a rise in fixed and possibly capped rate sales. But, with rates as low as they are, people can still afford a tracker. Even if base rates go up by half a percent, the tracker still comes in below a fixed or capped rate,” he adds.
But Rob Wakefield, market support manager at Yorkshire Building Society, says borrowers are growing more cautious about variable rate products as speculation on the next interest rate rise continues.
“In the early days, the best discount or tracker deals on the market will save the borrower money each month compared to the nearest comparable fixed rate. However, the borrower could well end up paying more than if they had taken a fixed rate at the outset following a couple of rises in Bank of England rates.”
Some lenders feel that mortgage brokers are partly responsible for fixed rate sales not fulfilling their sales potential. “Fixes are attractive at any time and, with pundits saying this is the bottom of the rate trough, people are becoming aware of the value of longer-term security,” says Alan Dring, head of sales at Standard Life Bank.
“There are a lot of borrowers that introducers are not getting to. I suspect that a lot more people would consider a fixed monthly lifetime remortgage payment than are currently being offered that proposition by introducers, who feel that a discount is an easier sell.”
Dring is especially concerned about the 'credit card' mentality, which sees many borrowers spend their discount away and wake up to a nasty shock when their mortgage reverts to the standard variable rate.
“Most people don't remember what they did with the discount. If they saw a comparison with the amount they could save on rate fluctuations through a 10 or 15-year fix, I think longer-term security would be more attractive. I don't think brokers explain caps and fixes to customers as a guarantee.”
But Ray Boulger says lenders have purely financial reasons for wanting to see more fixed and capped rate sales.
“It suits lenders to sell fixed and capped rates because they tie people in for longer. Also, most lenders price these rates up to make a profit, whereas most discounts are loss leaders. Brokers should be pointing out the pros and cons.”
With more than 10 times as many fixed rate products on the market as capped, brokers say capped rates are easily overlooked.
Steve Pollard, managing director of Edinburgh-based Moneyquest, says brokers talk about capped rate products less than fixed because there are fewer of them on the market.
“Not enough borrowers are offered a cap. If someone asks for a guarantee that payments won't go above a fixed amount, brokers should point out that two products actually fall into this category.”
Although fixed and capped rates may lack the flexibility of some of their variable rate cousins, they are a long way from one-size-fits-all. Pollard says it takes dedicated fact-finding to suit the right model of fixed or capped rate to a client's needs.
He illustrates this with the examples of a 4.79% two-year fix, two-year tie-in from Britannia Building Society, a 4.35% two-year cap, two-year tie-in from Portman Building Society and a 5.79% two-year fix, no tie-in mortgage from the Royal Bank of Scotland.
“On that basis, Britannia shouldn't get any business on that product at all, but brokers get into habits and may sell the lenders they know best,” he says. “The RBS fix has no tie-ins, but it may well be that borrowers are not fussed about having ties in the first place – if they can save 1% by taking redemption penalties, why not if they aren't going to do anything with the zero tie-in benefit?”
Right or wrong, fixed rates rule supreme among the current crop of mortgages for the security-minded. But having trundled along quietly for so long, caps are being polished up and may be poised to enjoy a big comeback.
The new breed of cap combination mortgages seems to offer it all – the safety of a capped repayment vehicle with a racy discount. Portman, Skipton and Coventry are just three lenders that have revamped their cap range.
At Coventry, John King says there is nothing like the thought of a market slowdown to concentrate a lender's mind on innovation. “The market has been so buoyant and providers are writing so much business that maybe lenders haven't had to put so much thought into their product portfolios,” he says.
“Mixing different types of product is going to continue and if the market starts to slow down – which I think it probably has to over the summer – I think we'll see more activity in the capped market.”
Tim Stone, senior mortgage consultant at Bristol-based Andrews Mortgage Services, says only a few lenders have ever bothered to design a good capped rate product.
“Because 99% of providers just used to stick the cap rate higher than the fixed equivalent, most people would go for a fix,” he says. “Introducing a cap into discount products does show a bit more innovation because it offers a cheap pay rate with added security.”
London & Country's David Hollingworth agrees that knowing which rate a cap works off is an important question.
“For example, if a cap is 0.5% below the SVR and works off the SVR, you've got to ask whether the rate is ever going to come down more than 0.5% to breach the cap. But now we're seeing lenders offering discounts that give a pay rate lower than 5% for instance, but one that is capped around 5.5%.
“For lenders, this is about keeping the cap competitive,” he adds. “If you put a 5.49% cap against a two-year fix, the cap will come nowhere. But combination products are the best of both worlds – giving a client the benefit of a lower variable rate for now and capping their exposure to rising rates later on. Depending on how fast a borrower thinks rates might rise, they could be getting a cheaper pay rate than the fixed rate option.”
Hollingworth cites GMAC's three-year cap of 5.29% as an example. Billed as a 'no tail' capped rate mortgage, this product tracks Bank base rates at a premium of 0.95% in the meantime, giving a current pay rate of 4.95%.
The more responsive model of capped rate mortgage might be a lender's pride and joy, but there are few signs that a similar makeover is on its way for fixed rates. Never mind, say brokers, who are already souping up capped and fixed rates themselves.
At EZI UK, Kevin Morgan believes so-called hybrid mortgages are not something that lenders necessarily market. “It is something that brokers do though,” he says. “For instance, we recently put £80,000 of a £150,000 mortgage on a fixed rate and the rest on a variable tracker. The objective is to see that £70,000 tranche paid off in five years through the client's ad hoc bonuses.”
Morgan sees such hybrids as an ideal way to use fixed rate money. Borrowers can enjoy the security of a fix or cap on parts of the debt they are not going to touch and pay the rest off more flexibly.
“The fixed or capped part provides stability and the tracker part allows the client to pay off the other part of their mortgage more flexibly and speedily. People like the thought of seeing a substantial part of their mortgage repaid within a five-year timeframe and, with rates where they are, that is a realistic option for many.”
Steve Pollard of Moneyquest agrees hybrids are a good way to put fixed rate money to work. “Hybrids are definitely getting more popular,” he says. “They allow you to take some of the mortgage on a two-year fixed or capped rate with penalties and some on a discount with none. There is a limit to how much a borrower can overpay, so it's a case of working out how much they think they can chip away at the loan over the two-year tie-in. You put that part of the loan on a discount – it's no problem to have a penalty on the fixed side in those two years because the client isn't going to make a dent in that loan anyway.”
But other brokers urge their colleagues not to expose clients to risks they do not understand – all in the name of extra repayment power they may not use.
Mike Waite, director of Royston-based Mortgage Quest, says that common practice is to find the level of risk a client is willing to take and to meet that need with a fixed, variable or capped rate.
“If you're dealing with hybrids, the consumer needs to be fairly knowledgeable to make that risk decision and it's hard for brokers to make it for them because of the inherent risk in the product,” he says. “If the client requires a fixed rate, but is also putting some funds into a discount, you are mixing the risk – so you've got to have a firm reason for doing it.”
But at Cheltenham & Gloucester, sales director Nick Hale defends hybrid mortgages as more transparent than the current array of cap/discount combinations. “We've always allowed people to put different parts of their mortgage on different products and prefer to do that rather than complicate the product range,” he says.
“Transparency at the point-of-sale is important both within the Mortgage Code and forthcoming regulation, and going down the hybrid route may be more transparent than complicated product combinations.”
Given how liberal lenders are with the 'flexible' word, borrowers could be forgiven for thinking that product providers are going soft on redemption penalties within fixed or capped rates. Wrong, says Nick Hale.
“Customers need to be far more mindful of the costs of remortgaging,” he says. “The blanket remortgage advice you read in the press is not good – you need to get the sums right in each individual case.”
David Connolly, product development manager at Mortgage Express, says lenders' generosity will never extend to dumping redemption penalties on fixed or capped rates. “The main issue with fixed rates is that the lender is committed to acquire funding for that term on the money markets. For the lender to pull out of that deal there is a cost – some of that cost is passed on to the customer and that will continue.”
Jennifer Holloway, head of corporate communications at Skipton Building Society, can even see redemption penalties increasing. “As a lender you're running a business, not a charity, and have got to make sure products are viable,” she says. “By reducing tie-ins the market has cut itself to the bone, so we might see them creeping in a bit more. But fixed and capped rates are definitely getting more flexible in terms of being able to make overpayments.”
Between compiling risk profiles, explaining combinations and putting together hybrids, it would seem there is no such thing as a straightforward fixed or capped rate sale for today's brokers. So just who do these mortgages suit?
First-time buyers with few savings and a fear of the financial unknown are classic customers. Ray Boulger of Charcol says that all things being equal, first-time buyers are more attracted to fixed and capped rates as they face a bigger payment than anything they've had in the past.
“The other people who should be looking at fixed and capped mortgages are those who will struggle to meet repayments if rates go up by 2%.”
But spiralling house prices do not always help borrowers choose the most sensible option in real life. Nick Hale says that first-time buyers want the lowest possible rate at the start of their mortgage, which may mean choosing a discount over a fixed or capped rate.
“I don't agree with the rationale, but it comes down to affordability,” he adds. “I would try to change that mindset and ask first-time buyers to look over the medium term, when they might see the benefit of a stable rate.”
Standard Life Bank's Alan Dring says short-term gain can be a dangerous game. “Most people do not utilise the discount in a positive way. They see it as less going out of the direct debit and, at the end of the period, the step up to higher rates tends to impact more.”
At Andrews, Tim Stone lists attitude to risk, promotion prospects and outgoings among the factors that decide whether a fixed or capped rate makes a good recommendation. While short-term fixed rates are popular with overstretched first-time buyers, longer-term products don't fare so well.
“The people going for five-year fixes are generally married and don't want to move during that timescale. First-time buyers don't want to lock into a product or lender for that time.”
A more mobile workforce has seen lenders back off from longer-term fixed and capped rate offers. David Connolly at Mortgage Express says that the majority of fixed and capped products are fairly short-term deals.
“I think now people are moving mortgage provider more than they used to,” he adds, “so for someone to commit to a 25-year rate just won't happen any more.”
But Standard Life Bank still sees long term security appeal to some, and offers a 25-year fixed rate product for people who want to pay one rate through their mortgage lifetime.
“Our 25-year fix is not being sought in the numbers that our other products are,” says Alan Dring. “But it's a satisfying niche for people as they realise that being able to guarantee repayments over the longer period is the best sort of security there is.”
Dring may not persuade every first-time buyer to pay more now on the possibility of saving more later. As the projected £29bn shortfall in pensions savings reveals, young Brits are all too cavalier in their attitude to the financial future.
But with extra flexibility and innovation coming through in fixed and capped rate mortgages, these products are becoming much more than a safer bet.
Borrowers caught in a fix of the past
Having revelled in rock-bottom interest rates for so long, consumers have come to think of any short-term fixed rate on the wrong side of 5% as expensive. After all, two-year fixes were flying off the shelves for closer to 4% at the start of the year.
How quickly we forget. Just 13 years ago, Bank base rates were touching 15% – and fixed and capped rates were priced even higher. Faced with a seemingly endless hike in interest rates, many borrowers thought they were slamming the brakes on their mortgage interest repayments by fixing their loan there and then.
Of course, rates started to come down as the economy recovered – leaving many borrowers stranded on fixed and capped rates that seem positively prohibitive now. Draconian redemption penalties and longer-term products were hallmarks of the 1990s mortgage market and some borrowers are still paying over the fixed rate odds to this day.
So should they simply remortgage? It's not as simple as that, says Kevin Morgan, managing director of IFA Ezi UK: “There are people out there with long-term fixes at 7% or 8%. We'd encourage them to look closely at remortgaging, but to be aware that some of the redemption penalties are pretty stiff.”
Jennifer Holloway, head of corporate communications at Skipton Building Society, says: “Obviously you'd need to look at redemption penalties and overall costs. Penalties reduce the further you go into a fixed rate period and, because a lot of lenders offer free legals, free MIG, etc., it can make sense.”
With rates unlikely to go much lower, Holloway says the time to remortgage onto a cheaper fix is now. “I certainly don't think rates are going to go lower, so it's a good time to fix if you're going to do anything.”
Nick Hale, sales director at Cheltenham & Gloucester, says brokers should not be too fast to remortgage borrowers, even if it means halving their pay rate. ” You have to look at how much it costs to get out of the existing deal and whether the client will be happy to lock into a new deal for two or three years,” he says.
“A lot of people are adding redemption penalties to their new mortgage, which is an expensive way of doing it. They are deferring the cost but adding extra interest payments and thereby extending the length of the mortgage.”
David Hollingworth, mortgage specialist at London & Country, says borrowers stranded on a high fixed rate should think carefully before jumping onto a cheap discount. “It's safer to go from fixed to fixed,” he says. ” It may be worth taking the penalty and getting it back in the savings available but if people remortgage from a fixed to a variable discount rate, the savings they calculate could be eroded if rates rise.”
Tim Stone, senior mortgage consultant at Bristol-based Andrews Mortgage Services, gives an example. “As a broker, you have to work out how many months it will take to recoup the redemption penalties by paying less per month. I calculated a £4,000 penalty for one client the other day, who would only save £2,500 by swapping – and that was onto a discount rather than a fix.
“I'm very dubious about recommending remortgage if the redemption penalties add up to over £1,000.”
How lenders price fixed and capped rate mortgages
Fluctuations in the pricing of fixed rate mortgages are as much an index of City confidence as a true reflection of official bank base rates. The cost of fixed rate cash on the money markets has bounced around for months – even though Bank base rates have been frozen at 4% since November 2001.
But predicting where interest rates will go next is always a gamble. With the Bank of England seemingly poised to increase base rates earlier this year, the money markets lost no time in marking up the costs of money to lend.
The costs of fixed rate products rose to reflect the City's expectations. But with the FTSE 100 now in trouble, money markets are admitting their pricing of an interest rate rise was premature.
Ray Boulger, senior technical manager at Charcol, says: “Very often the City overestimates the speed and amount of rate rises. As a result, the cost of money to lend goes up, which means lenders have to charge more on their fixed rate mortgages.”
Prices of fixed rate products are currently dropping back, after rising significantly from the end of last year. With traders still digesting record low inflation figures and the ongoing frailty of global equity markets, Boulger says the best fixed deals are still to come.
“The money markets have got it wrong in terms of where interest rates are going. We've already seen several lenders cut the price of fixed rate mortgages and there is more to come. It is a good time to look at fixed rates but not a good time to rush in because cheaper rates are on their way.”
For lenders, buying fixed rate money simply means getting a whole tranche of cash, which is paid back at an agreed interest rate. Capped rates are more expensive simply because they are harder to price.
Alan Dring, head of sales at Standard Life Bank, explains: “We've got to determine where the cap fits and what is the likelihood of exceeding that cap. So if a lender caps at 7%, but the market goes through 7%, how exposed does that leave them?
“Exposure is far more relevant in pricing a capped rate than a fix. You can buy fixed rates off the shelf in terms of buying SWAP rates but you're taking a risk with a cap. For instance, we had a capped rate of 6.49% but were paying over 7% for that at the end.”
Paying a premium for a capped rate becomes more viable if borrowers are prepared to sit tight for the longer term.
Ray Boulger says: “Broadly speaking, the longer the period a borrower is looking at the more worthwhile it is to take a capped rate – because the further ahead you look the more difficult it is to know where interest rates are going to go.”