A big danger for homeowners

With the base rate at 0.5% and heading for zero, mortgage interest rates have plunged. The threat comes when inflation returns and rates have to rise again...

As we revealed yesterday in Base rate cut to 0.5%, the Bank of England made it 'six in a row' by halving its base rate from 1% to 0.5%. Since early October, the Bank's base rate has collapsed from 5% to 0.5%, a fall of 4.5 percentage points in five months.

Going down with a tracker

I congratulate any homeowners who had the foresight to take out a tracker mortgage in recent years. The interest charged by these home loans follows the direction of the base rate, so monthly repayments have fallen out of the sky during this rate-cutting spree. However, one snag is that some tracker mortgages include a 'collar' below which the rate cannot fall, which limits the benefit to borrowers.

Thanks to the base rate being at a record low, it's now possible to find discount and tracker mortgages charging interest rates around 3%. Indeed, first direct offers a market-leading lifetime tracker mortgage with an offset facility which charges base rate + 2.39% (so currently 2.89%) a year, plus an arrangement fee of £799. However, in order to take advantage of this low, low rate, you need to have a deposit (or existing equity) of at least a quarter (25%) of the purchase price.

Rates are as low as they can go

After six consecutive rate cuts, there's not much ammunition left in the Bank's armoury. For example, two more quarter-point cuts would take the base rate to 0% -- something which has never happened in British financial history. Since the base rate cannot turn negative, zero interest would be the Bank of England's lowest possible lending rate.

If the base rate does fall to 0% or within a whisker of zero, then mortgage rates may come down a tiny bit more. However, we are clearly more or less at the bottom of this rapid rate-cutting cycle. Having come to the end of this round of rate cuts, mortgage interest rates won't fall much further, if at all. Indeed, some lenders -- particularly building societies -- are refusing to pass on the latest rate cut, arguing that they need to attract savers as well as borrowers. Others are just being plain greedy.

The danger of picking bottoms

One big problem with booms and busts is that herd behaviour becomes quite extreme at both ends of the spectrum. For example, plunging stock markets have led to widespread panic-selling, dragging down the share prices of solid companies as well as weak firms.

Likewise, I am worried that borrowers, seeing the ultra-low, affordable interest rates on offer, will be tempted to plunge into the housing market by borrowing as much as they possibly can - which will end up more than they can afford when, eventually, rates rise again.

It's still possible that, in the short term, we may experience deflation --falling prices for goods and services. If we do, then the base rate will surely remain low.

Then again, as the Bank uses all the methods at its disposal to stimulate the UK economy, lending pressures will eventually ease and inflation (rising prices) will return. As inflation creeps up, the Bank will be forced to raise its base rate, potentially quite sharply, in order to keep prices from climbing too fast.

For example, if the base rate returns to its 2008 peak of 5.5% - which was still historically very low - then mortgage rates (particularly the rates on today's tracker deals) would rise steeply. Indeed, borrowers who take out a new tracker deal today would suffer the full 5% increase, which could cause their monthly mortgage repayments to rise dramatically. The following table shows how things could pan out:

Monthly repayments on a £150,000 25-year interest-only mortgage charging base+2.39%

As you can see, if you took out the market-leading base rate tracker today, and the base rate went back up to the peak it reached last year, then your monthly payments would jump from £361 to £986 a month. That's a £625 increase every month or £7,500 extra over the course of a year - almost three times as much as you'd pay today! And bear in mind that this table shows an interest-only mortgage. A repayment mortgage would have even higher monthly payments.

In summary, while interest rates are very low, the temptation to borrow large sums becomes incredibly strong. However, in the words of US economist the late Herbert Stein, "If something cannot go on forever, it will stop." So, it would be unwise to assume that today's record low rates are permanently here to stay. Over the 25-year life of a typical home loan, rates are sure to rise to heights far above today's bargain-basement level.

So, don't over-extend yourself: borrow sensibly and budget for steeply higher mortgage rates. Instead of spending all that extra disposable income freed up by lower mortgage repayments, try building a bigger cash cushion in a savings account to weather the financial storm. After all, no-one knows how long and deep this recession will be, but one thing is certain: the base rate will not stick at 0.5% for the next three decades!

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