Those looking to acquire a home will notice that the mortgage interest rate is always higher than the bank rate. However, the difference between the mortgage interest rate and the bank rate (often referred to as the base rate) will vary in different situations. So, why is my mortgage interest rate higher than the bank rate?
How banks calculate their mortgage interest rate
Mortgage lenders consider several factors when calculating mortgage interest rates.
One of the primary considerations when looking at the difference between a mortgage interest rate and the bank rate is the cost of borrowing. There are various ways in which banks can borrow money to fund mortgages.
Customer deposits
When looking at mortgage interest rates, you will also notice that savings interest rates are always lower. This is because many banks in the UK use their customer deposits to fund mortgage arrangements. Consequently, if they pay 2% interest to savers, they will need to charge well over this rate to mortgage customers to make a profit.
Borrowing in wholesale money markets
There is also the option of borrowing in the wholesale money market, which is a market that brings together borrowers and lenders. This market is highly liquid, with literally billions of pounds changing hands daily, providing short, medium and long-term borrowing services at varying rates.
Debt instruments
While customer deposits and borrowing in the wholesale money market are the two primary sources of mortgage funding in the UK, some banks will use debt instruments to raise funds. This may involve using existing mortgage arrangements and other loans as collateral to secure additional funds.
Bank of England
As we saw during the US mortgage crisis, which led to a worldwide recession, the Bank of England will, on occasion, step in to provide liquidity to the banking sector. This is a helpful tool to support the banking system in troubled times.
Cost of providing mortgage funding
There are also many costs directly associated with providing mortgage finance, impacting the mortgage interest rate. These include:
- Staffing costs
- Regulatory costs
- Operational costs
- Third-party commissions
- Advertising costs
Lenders spread these direct costs across many mortgages, in the hundreds of millions or even billions of pounds. However, they still need to be considered when calculating a bank’s mortgage rate.
Risk
The profit margin on any financial arrangement is directly related to the risk. Therefore any lending, such as mortgages, personal loans or business loans, requires a degree of risk. This is known as the risk/reward ratio, which means that the greater the risk, the greater the potential reward. Therefore, all things being equal, lenders will primarily consider the loan to value (LTV) ratio when it comes to mortgages.
When looking to acquire a property, the recommended minimum deposit is 20%, but this can be as little as 5%. In the case of a 20% deposit, the risk is lower, as shown below:
Property value: £500,000
Deposit: £100,000
Mortgage: £400,000
There is £100,000 of “headroom” in this scenario, which is the difference between the mortgage and property value. Consequently, if the property’s value were to fall by 10%, then, in theory, there would still be a £50,000 gap between the value and the outstanding mortgage. If we look at a different scenario with a 5% deposit:
Property value: £500,000
Deposit: £25,000
Mortgage: £475,000
If the property’s value fell by 10% to £450,000 in the early days, there would be insufficient to cover the outstanding mortgage. Consequently, if the mortgagee defaulted and the lender sold the property, the sale proceeds would not cover the outstanding mortgage.
There are other risks to consider, such as income and age, but you will generally notice that the lower the deposit on a property, the higher the mortgage interest rate.
Competition
Competition in the mortgage sector also significantly influences headline mortgage interest rates compared to the bank rate. When the economy is booming, employment is down, and household incomes are relatively secure, this takes away part of the risk factor. In the risk/reward ratio context, as the risk lowers, the required reward is lower. In this scenario, mortgage lending is seen as relatively safe, which injects a more significant element of competition.
Credit history
In the aftermath of the 2008 US mortgage crisis, which led to a worldwide recession, regulators moved to introduce a mortgage affordability test. This ensures that only those able to repay their mortgages will have their applications approved. This created a greater degree of security for the sector. However, the margin by which applicants pass their affordability test will impact their mortgage interest rate. One of the main factors taken into account is your credit history and ability to manage your money.
Profitability
There needs to be a degree of profit to attract new mortgage lenders to the market and retain existing participants. The degree of profitability required will depend upon the applicant’s circumstances and the risk/reward ratio. Even though the UK mortgage sector is enormous and would not necessarily be impacted by the withdrawal of a small number of lenders, this may not be the case for niche markets.
If major lenders in, for example, the buy to let sector were to withdraw from the market, this would impact competition. As the competition lowers, mortgage interest rates would likely rise. Good old capitalism is alive and kicking!
Different types of mortgages attract different rates
When researching mortgage interest rates, you will come across introductory offers, standard variable rates and fixed-rate mortgages. There are several factors to consider with these mortgage arrangements.
Introductory offer
While pitching the initial mortgage interest rate at a level attractive to potential customers, these rates tend to be relatively short-term. In this scenario, it is essential to consider the mortgage lenders’ standard variable rate and whether this is competitive against its peers. Once the introductory offer ends, you will automatically revert to the standard variable rate unless you can arrange an alternative mortgage.
Standard variable rates
While standard variable mortgage rates will not necessarily move in tandem with base rates, the direction of travel will be similar. This is because mortgage rates tend to move ahead of a Bank of England base rate announcement, with the change often flagged before being made public. Consequently, you may not necessarily see a like for like increase on the day of the announcement.
Fixed-rate mortgages
On the scale of mortgage rates compared to Bank of England rates, we have the introductory offer, the standard variable rate, and the fixed mortgage rate. Fixed mortgage rates tend to be the greatest of the three simply because of the increased risk. So, for example, with a mortgage lender, you may find that their variable rate is 3.5%, but the three-year fixed rate is 4%.
This rate tends to be greater because of the expected trend in interest rates and the risk that they could move even higher than expected over the three years. So, the fixed rate will involve a degree of expectation and the risk that this expectation changes.
The risk/reward ratio and borrowing costs
Even though there are many factors to consider when calculating mortgage interest rates, you can cover most under one headline, the risk/reward ratio. While there needs to be a degree of profitability in all mortgage arrangements, the level of reward required is directly related to the risk taken. Some of these risks are out of the control of individuals. While others, such as credit rating and income, can be influenced by the mortgage applicant. However, the ultimate foundation for the mortgage industry relates to the cost of borrowing, measured by UK base rates.
While base rates and mortgage rates may not always move in tandem, they will always move in the same direction.