On 16 January, the average rate on a new two-year fixed-rate mortgage was 4.78%, according to the financial data company Moneyfacts. Two months later, it was 5.20%. Between those two dates, the Bank of England voted to keep the base rate at 3.75%. More significantly, though, the US and Israel carried out airstrikes on Iran and a conflict broke out.
The US air attacks on Iran have caused economic shocks across the world. Stock markets have tumbled, petrol and heating oil prices have gone up and there have been warnings of higher bills to come, for everything from food to holidays. All of this feeds into interest rate expectations, and from there into mortgage rates.
Most mortgages are offered on a fixed interest rate – meaning you are guaranteed that, for a set time, you will be charged the same rate. In the UK this will typically be for two, three or five years, and funded by a mixture of money saved in banks and building societies and money that lenders have borrowed on the wholesale markets. This is where swap rates come in.
Swaps are a financial instrument used by banks to manage the risks posed by interest rate changes. They involve one bank paying a fixed interest rate to another, in return for that second bank paying it a floating (variable) rate – the first bank “swaps” the risk from a possible rise in interest rates with the second bank.
To provide the money for mortgages, “lenders use their own funds and also borrow money at variable rates, which comes with risk”, says Adam French, head of consumer finance at Moneyfacts. “They swap the interest rates on these cashflows for a fixed rate … That’s how they manage the risk. They’re not swapping cash; they’re swapping interest rates.”
Olly Cheng, senior financial planning director at the wealth management company Rathbones, says that while a fixed rate gives certainty, a variable rate could be better value over the period, and the parties who are happy to swap these two scenarios enter into a contract.
“Each side willingly takes on a different type of risk (fixed or variable) and the swap simply sets the rules so the exchange is fair,” he says.
Say I borrowed £100,000, which I decided to lend out again. I am being charged an interest rate that matches the base rate – currently 3.75% – and I want to make a profit, so I charge the person who is borrowing it 4.75%. But I have promised to fix the rate for two years.
If the base rate stays as it is or falls, I will be earning a good profit because my cost of borrowing will stay the same or get cheaper. But if the base rate rises, that will eat into my earnings, so I find someone willing to take on the risk and pay the floating (variable) interest rate, in return for me paying them a fixed rate. They will now be the ones benefiting if interest rates fall, but I will be shielded if they rise. The fixed rate is the swap rate.
The swap is arranged on the set sum of money – so in my case it would be interest on £100,000 – and the fixed rate is set so that over the course of the contract we should expect to pay each other the same interest at the end. This means the swap rate takes into account where the base rate is expected to go over that period.
Swap rates rise when investors expect interest rates to be higher in future, meaning it is more expensive for lenders to borrow.
They also reflect risk, says Neal Hudson, a housing market analyst at the consultancy BuiltPlace. When there is a lot of risk of things changing, as in the economy currently, this is reflected in higher swap rates.
The rates move up and down throughout the day. “Like a lot of financial instruments, they are based on what price people are willing to take at any given moment,” says Cheng.
Before the US’s first airstrikes, the Bank of England had been expected to cut interest rates twice this year, from their current level of 3.75% to maybe 3.25%. This was because there were signs that inflation was falling, meaning it could reduce rates and encourage consumer spending. The events in the Middle East reset the forecasts. Instead of falling, inflation is expected to rise again. The Bank’s job is now to try to limit it, which means it will consider putting up interest rates.
French says that last Friday five-year swap rates had increased to 4.03% from 3.603% on 2 March. “This is a big jump,” he says. The swap rate can be taken as an indication that markets are expecting at least a 0.25 percentage point rise over the next five years.
Cheng says swap rates are the most important factor in mortgage pricing. “Other factors do play a part, as some of what you pay for a mortgage is the bank’s profit margin, and the level of margin can go up and down depending on the risk appetite of banks, and the number of transactions they are doing.”
Hudson says the risk factor is important at the moment. “No one wants to be the person who is overwhelmed by everyone piling into their [mortgage] product,” he says. “No one wants to be the best-priced product for too long and become overly exposed to the market where there is such volatility.”
As well as being worried about the cost of the mortgages, lenders may also be worried about the future trajectory for house prices if the war goes on for a long time and causes a squeeze on other living costs. Lending a lot on homes that slump in value will not be good for business.
This, together with the volatility of the rate, is why mortgage deals are being pulled and repriced at record speed. French says: “There’s usually a lag of one to two weeks, but recently that’s not been the case. We’ve seen things happen so much quicker because rates have shifted so much.”
So far, the two-year swap rate has not gone as high as after Liz Truss’s disastrous mini budget (to give it its full title). Soon after that it went up to 5.75%, even though the base rate was just 2.25%. The next July, it went as high as 6.24%. On Monday it was just under 4%. If the war ends soon, swap rates and mortgage deals could soon be back on a downward curve. If it doesn’t, you should probably expect to pay more.
