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Stick or twist?
There has been a number of articles of late about this subject - fixing your buy-to-let interest rate. With talk of unemployment falling to the Bank of England's threshold to consider an interest rate rise, undoubtedly we investors need to make judgments and plans for the future with regard to our own borrowing decisions.
I am glad that this article discusses one aspect of fixing interest rates that often gets overlooked as people instead tend to focus on 2 different headline things – 1) the level of deposit / equity required, resulting in what loan to value is used and 2) the interest rate that you will pay...the often missing aspect is the fees involved. In order to evaluate the true cost of a mortgage and to be able to compare different packages from the marketplace we need to look at the total cost of borrowing over the fixed term. This includes the set up fees but should also be cognisant of early repayment penalties during the fixed period; typically there are none after the end of the fixed term however, which is a relief.
I have looked at a couple of scenarios recently myself: the first was a new purchase and of course we compare one lender against another but equally available products from the same lender with each other. Many have low fee / higher rate combinations vs. higher fee / lower rate alternatives - which is incredibly confusing! The other situation that I looked at was what to do with an existing loan towards the end of the fixed rate period.
Having worked in financial services for much of my career I understand there is always a risk / reward trade off as many of us will also appreciate but perhaps less well known is that actual charges for borrowing to us usually bear no direct correlation to the Bank of England Base rate – first there is the thing known as SWAPS mentioned in this article - the rates which banks will lend to each other. In addition to the SWAP rate, banks add on extras to their own cost of borrowing for the following to name but a few: credit risk premium, bad debt premium, own return on equity premium, operational cost premium, acquisition cost premium, capital contribution and oh yes profit! So, all of this adds up and explains why when Bank base Rate is 0.5% that we get typical mortgage rates in the range of 3-5%! Then factor in the up-front fees and again, as the article highlights, this has the effect of adding between 0.3% to the rate on a 5 year fixed deal to as much as 0.75% on a 2 year deal.
But here's the thing...what if rates don't go up, or take a while to go up or even fall instead - we will have paid fees to protect ourselves when we did not need to?! But as I already mentioned, it is a question of risk vs. reward and so personally I tend to try and fix for a 5 year term if at all possible.
Now the 2 year fixed deals are a different matter as far as I am concerned. Returning to my two scenarios mentioned earlier - with the existing mortgage one, I was offered a range of options to fix for a new 2 year period. You will recall that on average the fees would add an extra 0.75% to the interest rate in my loan...or to put it another way...the variable interest rate that I would revert to at the end of the fixed period would have to go up by 1.5% at the end of the first year to make a variable rate deal as expensive as my fixed rate deal with the fees included. In a stable interest rate environment this seems like an expensive premium to pay BUT if something unpredictable were to happen I would be clobbered I guess; so that is a risk that I decide to take or not. How I make my decision is simple - I may protect myself for 2 years only anyway with the 2 year fixed option, so if I take a risk on interest rates remaining stable or even only rising a little I should be OK, so if the risk premium of fixing for 2 years is high (i.e. here 0.75%) and I believe the market is relatively stable, I would probably go with variable for now and fix later or go with a longer term fix instead. To me the 2 year fix option seems something of…err…a fix to be honest!
If fixing, that leaves the 5 year option as being the better value option at a +0.3% premium and also a better risk avoiding hedge against interest rate rises to consider with 5 years to not worry for.
Now, without getting too technical, there is something called the yield curve in finance and basically this shows the different interest rates available for different fixed financing periods. In the last couple of years, the yield curve was heading downwards as interest rates were stable or even falling and so fixing for 5 years was actually relatively cheap and 2 years was even cheaper...before adding in the fees. Now the yield curve is starting to reverse, as most experts expect rates to increase over the next couple of years and this is pushing up the cost of 5 year borrowing in particular. I realize by now that I am rambling a little, so I will get to my point...5 year fixed rates starting to rise is an indication that the financial experts expect interest rates to rise generally over this period and so fixing for a longer period now probably makes some sense!
A premium of 0.3% to cover the cost of fees is reasonable and if you can add it to the loan it also means spreading the payment over time anyway...so in conclusion, yes I would say that now is the right time to look to fix your borrowing but looking at 5 years rather than 2 would probably be a better bet in my opinion at least. Wait too long though and the costs will start to rise as the finance providers seek to hedge their risk also
So, right now for me…stick it is then...
Source & credits: This is Money