Trackers Vs. Fixed Rates

With inflation increasing but an interest rate cut on the horizon, should mortgage borrowers go for a tracker or a fixed rate?

There's been a lot of doom and gloom about the economy in the news recently. But while the financial crisis is certainly bad news for bankers and cityboys, it's not necessarily bad news for mortgage borrowers.

Why not? Mainly because it makes the possibility of interest rate cuts more likely. The Bank of England is under pressure to prop up the stagnating economy and a cut in its base rate might do the trick.

This creates a dilemma among mortgage borrowers looking to take out a new deal over the coming weeks.

With a rate cut on the horizon, it may seem like a foolish (note the small f!) time to take out a fixed rate. Because if the Bank of England base rate does fall, fixed rate deals are likely to get cheaper. You could save yourself a lot of money just by waiting a few months.

Alternatively, you could take out a tracker. This will track the fall in the base rate, so your monthly payments will get cheaper.

However, with inflation on the rise, there is also a decent chance that - at some point in the next few months or years - the base rate may have to rise. After all, the Governor of the Bank of England, Mervyn King, is supposed to use his control over interest rates to keep inflation at 2%. In August, inflation reached a whopping 4.7% - that's the highest it's been in more than 16 years!

So, long-term, a tracker may not be the best option either.

What's the best way to deal with this situation?

Track, then fix

If I were taking out a new mortgage this month, I'd want to go for a tracker over the short-term. Then, if the Bank of England cut interest rates - or if it suddenly seemed likely the Bank would raise interest rates instead - I'd immediately switch to a fixed-rate.

That way, I'd be sure of benefiting from any cut in interest rates, but I would be offsetting some of the risks of a tracker for the security of a fixed rate (where the rate stays the same, no matter what happens to interest rates).

Hold on! There's a problem with this strategy - nasty little things called ERCs (Early Repayment Charges). These charges apply if you want to switch your deal before the tracker or fixed rate ends, and they will often be as much as 3% of your outstanding mortgage: so £6,000 on a £200,000 debt. Eek!

How do you avoid them? Well, one way is to take out an ERC-free tracker. These lovely deals are the acrobats of the mortgage market. In other words: flexible. They allow you to remortgage at any time without having to pay the ERC penalties. So you're free to switch onto the best deal available, whenever you like.

The problem is, mortgage lenders make you pay for the flexibility of ERC-free trackers. Through the nose.

For example, Hinckley & Rugby Building Society offers an ERC-free ` lifetime flexible tracker' at 1.19% above Base Rate - so currently an uncompetitive 6.19%. The arrangement fee is £749, plus there are other up-front fee of £195, bringing the grand total to a whopping £944. Plus, you must have a 25% equity stake/deposit in order to be eligible for this deal.

Compare this to a market-leading two-year tracker - with ERCs - from Nationwide. The rate is 0.93% above Base Rate - so currently 5.93%. And the booking fee is only £599, plus a redemption charge of £90, bringing the grand total to a relatively cheap £689.

As you can see, the ERC-free tracker costs you an extra 0.26% in interest a year, plus £255.

It's not a huge difference - but it shows that you do have to be prepared to pay a bit more for flexibility.

Another way

If you like the idea of:

a) taking out a tracker

b) having the ability to switch to a fixed rate whenever you like, but

c) don't want to pay extra for that freedom.

Then there may still be a solution for you.

Nationwide, Lloyds TSB and Natwest all offer a `drop lock' facility. This means, if you take out a tracker with any of these lenders, you can switch at any time to one of their fixed rate deals - without having to pay an ERC.

Sounds brilliant, doesn't it? Unfortunately, the ERC still applies if you switch from the tracker to any deal from another lender. So you will be limited in your choice of fixed rates. For example, if you took out a Nationwide tracker, you would be able to switch to any Nationwide fixed rate at any time, without any penalties - but you would have to pay the ERC if you remortgaged to a fixed rate with another lender.

There's no guarantee that the lender you chose to go with today will have a competitive fixed rate a few months' down the line. So that's the risk you're taking with this approach.

Plus, you'll have to pay a new booking or arrangement fee when you switch to the new deal. So, in terms of fees, it could work out quite expensive.

Still, I think it's worth bearing this facility in mind if you are interested in a tracker deal from any of these lenders. Nationwide in particular has some very competitive trackers out there at the moment - speak to a mortgage broker at The Motley Fool Mortgage Service if you want to see how their deals compare to the rest of the market.

Stay on the SVR

Your final option if you're remortgaging is to allow your rate to automatically revert to your lender's Standard Variable Rate (SVR), when your current deal finishes. But with most lenders charging 7% or more, your monthly payments may rise sharply. It may also work out more expensive than an ERC-free tracker over the long-term. (A broker should be able to help you figure out what the difference would be on your mortgage.)

As you can see, there is no simple solution to this dilemma. But there are lots of options. And at least there is finally, finally, FINALLY some good news for mortgage borrowers!

> To find out more about any of the deals mentioned above, speak to a broker at The Motley Fool Mortgage Service