Image source: bloomberg.com
The health of the global economy is gradually improving. Investors know that interest rates cannot stay this low forever, and that central banks will begin to raise rates as employment figures rise. US analysts are predicting that the Fed could ease its bond-buying program soon and that interest rate rises are the natural evolution of that policy.
Investors are also looking elsewhere to see which central banks are getting ready to act. In the UK, the double-dip recession has been revised away, unemployment is falling steadily, and economic growth is faster than in any other European economy.
However, there is a key problem that few homeowners have yet considered, but which could have a dramatic impact on their personal finances and on the wider economy. Interest rates are currently at historic lows, and have been for a number of years. As the economy improves at an increasingly quick rate, many are now concerned this might imply a rates increase sooner rather than later.
The Bank of England, which sets interest rates in the UK, has suggested that they could be set to rise from their current level of 0.5%.
Mark Carney, Governor Bank of England
Image source: www2.macleans.ca
New governor Mark Carney issues “forward guidance” to the markets, informing them of the bank’s intentions around future interest rates. In this break from tradition, he revealed that an unemployment level of 7% in the UK would start the discussion about increasing interest rates. Unemployment has fallen to just 7.6%, with analysts expecting the maximum 7% threshold to be breached in the very near future. This will lead on to prompting the discussions of interest rate hikes that could spell financial stress for millions of homeowners.
Some basic number crunching reveals that this is not good news. A 1% rise in the base rate of interest will add around $1,500 per year to the average cost of a mortgage. And through the timeline of interest rates history, we are currently at the lowest rates for borrowers ever. If these rates are allowed to step up, even back to the long-term average of 5%, the implications for householders could be significant. At the same time, these rate rises may be required to dampen inflation and encourage saving, and for the central bank, it is a question of whether they reward homeowners or savers.
One way to circumvent the volatility of interest rates is to opt for a fixed rate mortgage. These offer a worse deal to start with, but have the benefit of being fixed, or fixed for a period. As a result, homeowners know exactly what they will be spending, no matter if interest rates go up or down. This may be a useful thing to think about for those who are considering entering into a mortgage, but who don’t want to be exposed to these same vulnerabilities. The same is true for business leaders, such as Stephen Dent, and commercial borrowing.
Interest rate hikes are inevitable at some stage. For those exposed to this risk, it is a good idea to think through now how you would afford your repayments if interest rates went up to 5%. Beyond that, it is also worth planning for higher interest rates still, applying your own financial stress tests to see how these developments would affect your circumstances. What is already clear is that there is a need for homeowners to be wary, not just for themselves, but for the effect this could have on the wider economy.