The property market's worst-case scenario

Consider the worst-case scenario of rapidly-rising interest rates and sharply falling house prices. How would this affect you and are you ready for it?

If inflation pushes up mortgage interest rates hard and fast some time in the next few years, would you homeowners be ready for it?

Many may be hoping that any large rise will be countered with higher wages and higher house prices, since they are also affected by inflation, but we can't hold our breath that these things will balance out as nicely as we want, particularly in the short-term.

There's no such thing as normal

This decade it seems that commentators are calling rates around 5% “normal”. The reality is that in ten or even two years, interest rates could be at 5% or they could be far from “normal”. Still.

Right now they are at 0.5%. In years to come they could still be there, or they could be around 10%. The latter is just as likely as anything else, particularly with all the money printing that's been going on, courtesy of a government determined to devalue its debts.

To show you how hard and fast and sharply interest rates have moved up and down throughout most of our history since the 1840s, take a look at this visual display courtesy of the Guardian. (Click Start and scroll through time using the blue bar at the bottom.)

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Those sharp changes throughout most of the past 170 years are not guaranteed to happen again any time soon, but they do demonstrate that a big swift “surprising” rise is far from a radical idea.

(Surprising to economists anyway – a bit like buzzword bingo I always watch out for reports of economists being surprised by the latest movements of the stock market, the economy, interest rates and everything else. Some of them seem to be in a permanent state of raised eyebrows.)

We really can't predict how high rates will go, so for our “worst-case scenario” consider a rise of five percentage points on whatever it is you're paying now. So if you're paying, say, 3.5%, our scenario is in the next few years you end up paying 8.5%.

Naturally we could come up with an even worse scenario than a five percentage-points rise, and then another one after that. But we're not the four Yorkshiremen, so we have to draw the line somewhere. I've drawn it here because I think at this level most people who stay variable now will have regretted not fixing.

Can you find an extra £3,000?

This is what it might cost you. If your mortgage is around £100,000 and has ten to fifteen years left, with an increase of five points you can expect to pay between an extra £230 and £280 each month – around £3,000 per year.

This is assuming you currently pay something between close to zero and around 4%. If you have a more expensive interest rate or if your mortgage is longer than 15 years, you should expect the extra monthly cost to be somewhat higher. If your mortgage is more than £100,000 this will also increase the cost.

You can get a good idea of how much your own mortgage would cost you by using lovemoney.com's mortgage calculator. Type in your current mortgage details and add on five percentage points to your current rate.

Falling house prices

It's far from certain that house prices will fall if rates rise rapidly, but consider the possibility that they could do so by 30%, which is about as far as most (if not all) property “bears” think prices will fall.

To do the maths, take what you think your house would now sell for and multiply that by 0.7 on your calculator. The new figure is your house price minus 30%.

If that figure is lower than your mortgage and rising interest rates would put you in difficulty, you are in danger of insolvency. As a higher risk case, a good long-term fix is particularly appropriate for you.

The case for fixing sooner

If you now select a short deal (variable or fixed) of two or three years, rates could easily rise far in that time. When your deal expires, you would then have the difficult choice of either fixing high or risking staying variable.

Some of you are staying flexible on standard variable rates, ready to leap into a fixed deal at the first solid sign of rising interest rates. I recommend caution with this strategy. It's clear from readers' comments and other articles that many people think it will be child's play to lock into a good rate as soon as interest rates begin to move. This is an assumption that might prove false.

At each whiff of potential higher rates, and certainly when the first “surprise” rise occurs, there will be an extraordinary rush for fixed deals which may spread like wildfire with each report quoting an astonished economist. It will be hard to know in the early months which signs are false alarms, meaning you may miss the boat.

Let's say you're reasonably quick – many other applicants probably will be too. By the time the lender has waded through to your application, it may have withdrawn deals and replaced them with higher rates several times, due to demand and other pricing forces. Then you'll have the anxious dilemma: choose to accept defeat by fixing much higher than you could have done now, or hold tight to the variable rate rollercoaster – as variable deals will be priced to start a little cheaper – hoping rates don't climb too far or too fast. I wrote more on this in Pay 5% on your mortgage for a decade.

So take stock and ask yourself if you could afford a big rise. If you'd really struggle, it may be a good time to fix. The best five- and ten-year fixes are between 3.5% and 5%. That might seem high compared to what many of you are on now, but in historical terms those are excellent prices for such lengthy peace of mind – and only one arrangement fee.

If you take a long fix, you may curse me and slam your fists on the table in years to come if interest rates stay low for many years, but if higher rates would have killed you, it will still have been an intelligent decision with the information you have at this point in time.

More points to consider

Make adjustments to your budget now to save on worry later. Even an extra £1,000 in the bank could help delay any problems of a shortfall in income due to higher rates. That'll give you more time to find a lasting solution.

It could be that earning more money is your back-up plan. Think about how you could earn a second income or prepare a spare room for a lodger, possibly someone who lost their home due to higher interest rates.

If you're overpaying, that's wonderful: it can cut the cost of your mortgage dramatically and it will  reduce your costs when rates go up, but bear in mind that, if you overpay and leave nothing in reserve, you could be in grave difficulty if you can't afford the higher repayments.

More: Compare mortgages through lovemoney.com | Pay 5% on your mortgage for a decade | How to pick the right remortgage deal