We're being encouraged to take short-term trackers. If lenders want us on short-term trackers, doesn't that make them a little fishy?
Investors are often encouraged to invest against the grain. 'Contrarians' they're called. Many investors want to be contrarians, but it takes guts. I'm going to explain why it may make sense to be a contrarian mortgage customer, but that too will take guts.
Intuitively correct mortgage deals
The UK is taking some hefty inflation-boosting measures in order to get the economy growing and to avoid deflation. Increasing inflation will probably be contained by increasing interest rates.
What's more, the risk to interest rates is currently all to the upside, because mortgages can't get much cheaper. This means fixed-rate mortgages should be more attractive to us than tracker mortgages. Plus, short-term tracker deals should be more attractive than long-term tracker deals, because they won't tie you in for as long if interest rates begin to rise.
It's not that straightforward.
Trackers are cheaper
Lenders price fixed and tracker deals differently to protect their profits regardless of what happens to interest rates. This makes our decision on whether to fix much harder.
The following figures are based on a couple I invented, Mr and Mrs Remortgager, who need a new, 15 year, £115,000 mortgage for their £170,000 home.
The best two-year trackers for Mr and Mrs Remortgager come in at around £20,000 over two years, including all fees and charges and assuming interest rates don't rise. The Remortgagers' best two-year fixed deals would cost them around £21,000.
£1,000 extra isn't a huge amount to pay for peace of mind, but it's a short deal, so that benefit isn't so great.
The premium paid for fixed deals
Interest rates may rise suddenly with no or little warning. A two percentage points jump one year from now would result in the Remortgagers paying a few hundred pounds more in total with the tracker than the fix (i.e. more than £21,000).
Let's look further into the future: five years. Assume that the Remortgagers go for a two-year tracker and switch again at the end of the deal:
- If interest rates don't rise for five years, they could pay around £50,000 over the period (including remortgaging costs).
- If rates rise three percentage points in two years and then remain stable for the next three years, they might pay around £57,000 over the period after remortgaging - that's an additional £7,000.
The best fixed deals for five years that the Remortgagers can get at present are also around £57,000 over the period. This means that mortgage lenders are factoring into their fixed deals roughly a three percentage points rise in interest rates in about two years' time.
If rates were to rise even faster or further than three percentage points, the Remortgagers will have lost out if they go for a tracker now. If rates rise more slowly or not as far, they'll have done well.
Three percentage points in two years seems like a sensible safety margin for lenders. All their loans will likely be in profit if rates rise no more than three or four percentage points. Fixed deals may become unprofitable if rates rise somewhat more, but since most people are opting for trackers or to fix for just two years, this isn't a serious problem for lenders.
The deals are equal
What this demonstrates is that the appeal of fixing your mortgage against rapid or significant rises in interest rates is effectively neutralised by the extra cost of fixing.
Most people realise the big difference in pricing between fixed and tracker deals, which is why a little over half of you are currently choosing trackers. Still, I hope the numbers I've given you so far have helped you to get a better idea of the premium you'll pay for a fixed deal.
Nothing I've said so far is particularly contrarian, but my next point is:
Consider long-term trackers
It is more intuitive to go for short-term trackers rather than long, but this is where my instincts tell me it's time to become a contrarian.
More people are turning to short-term trackers, because they want to be able to switch to a fix in a couple of years if rates rise. However, rates can rise rapidly. In the 16 months from December 2007, interest rates moved more than five percentage points. Anyone tied into a two-year tracker now may see similar increases before they can switch. The worst part is that there's no escape at the end of the deal: all the offers you'll then face will be more expensive, including the fixed deals.
With a long-term tracker, you usually aren't tied in with Early Repayment Charges if you want to switch to another deal at any point.
Plus, because lenders are making short-term deals more expensive, they're bringing down the cost of long-term trackers. Some long-term trackers are currently as cheap as short-term trackers, e.g. with ING, First Direct, HSBC and Mansfield Building Society.
Sure, you're likely to have a bumpy ride and may suffer large rate increases, but everyone else - who will be remortgaging every few years - will face the same ride just with larger bumps.
What's more, they're not likely to predict correctly the future of interest rates every time they switch, and they'll probably have to pay a fee each time to get the deal as well.
Of course, your other option is to go for a long-term fixed rate. But if you did this, you'll end up paying a lot more than you have to over the next few years. And you'll be tied in for a long period. So again, it's a gamble.
If you do decide to go for a long-term deal, just bear in mind you'll need guts to hold on to it, whenever you see the tempting short-term products on offer!
I have to say it
Sorry to offer the same old advice, but it's essential. You should only borrow if you can afford the repayments and, unless you're going for a fixed deal of at least five years (preferably longer), you should be able to afford significant increases in interest rates over the coming years.
There are thousands of different mortgages and we're all different, so the best deals for you and the total cost over two and five years will vary. You can compare mortgages using lovemoney.com's mortgage service.
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