Borrowers: beware of payment shock!

Mortgage borrowers on low SVRs think they are sitting pretty... but actually, they are sitting precariously!

Mortgage lenders' Standard Variable Rates (SVRs) have enjoyed a boom during this recession due to uber-low interest rates of 0.5%. In many cases SVRs are lower than the new deals being launched by the same lenders. For a remortgagor faced with the decision of automatically moving onto the default cheap SVR or choosing a new pricier deal, it's often a no-brainer.

This is a turnaround as the industry, the pundits and the press have spent the last decade telling borrowers to get smart, get savvy and get off the SVR. Pre-credit crunch lenders paraded their 'new borrower' deals like tropical birds displaying their exotic plumages. 'Take the switching challenge' they squawked as they waved their fixed rate feathers in our face and tickled our fancy with trackers.

This colourful, competitive mortgage market was replaced in 2008 with something more grey and uninspiring. Like birds of a feather lenders flocked together, and within months virtually all pulled their riskier high loan-to-value products (for those with small deposits) and banned new borrowers from accessing their low SVRs.

But they couldn't stop existing borrowers from taking the SVR option so remortgaging has dropped off a cliff. In August just a third of all mortgage lending was to remortgagors -- a massive 57% drop from 12 months earlier, according to the Council of Mortgage Lenders.

But are all these borrowers sitting on their lender's SVR doing the right thing?

Cheap and cheerful

Well, they are probably paying less for their mortgage than had they switched to another deal. And they haven't incurred switching costs which average close to £1,000.

But of course it all depends on what lender you are currently with and what its SVR is. Come to the end of a deal with Cheltenham & Gloucester for example and you will revert to a default SVR of just 2.5% -- hard to beat. But if you are with Chelsea or Leeds Building Societies, you will move onto an SVR of well over 5%, in which case you might be able to do better with a new deal.

It's also dependent on the level of equity you have in your home, since that affects which new deals will be open to you. If you have over 40% you will be able to access virtually all of the deals on the market, so it could be worthwhile switching to a best buy. But if you have less than 25% equity you will have to choose from a limited number of products that could be more expensive than your lender's SVR. Of course, it all depends on your individual circumstances.

As well as paying less each month and saving on switching fees, staying on SVR has another advantage. It's a good temporary measure since you are not tied into the rate. SVRs usually come free of any early repayment charges meaning they are a good place to 'park' your mortgage while you can take advantage of the low rates. If rate begin to rise there is nothing to stop you switching to a fix.

Storing up problems

But while SVR is currently a great option, it's not failsafe and some mortgage borrowers might be concerned about what will happen when rates rise.

And they are right to be worried. Rates will increase -- that's a given -- although nobody knows when.

The best guess (or the general consensus) is that they might start to go up in the second half of 2010. However, how fast they will increase and how high they will go is anyone's guess. Bear in mind that for most of last year base rate was at 5% or higher. The current 0.5% is historically low.

So you could be in for one heck of a payment shock.

For example if you are currently paying two percentage points above Base Rate (2.5%), it is not unreasonable to assume that if Base Rate rises to 5% your SVR would go up to 7.5%.

What does this mean for your repayments?

• At 2.5% a £200,000 25-year repayment mortgage would have monthly repayments of £897
• At 7.5% these repayments would shoot up to £1,478, an increase of £581 a month.

Could you afford for your mortgage payments to rise by over £500 a month? Even if the base rate doesn't shoot back up to 5%, the prospect of your monthly repayments rising by £100 or £200 are very real indeed.

So what should you do?

Move to a fix

One option is to switch to a fixed rate mortgage now. Chances are this is going to mean an increase in repayments unless you can get one of the best buy deals. But in return you will be rewarded with complete payment security for the length of the fixed rate deal, whatever happens to the base rate.

This could be a useful option if you can afford a little more now but really cannot afford a significant increase in repayments. Of course, you could always wait until rates rise and then switch into a fix, but there are no guarantees that the deals available will be as good as they are right now (and they are not that amazing now!).

Build up a buffer

If you want to take advantage of your lender's super-low SVR but you are concerned about rising rates there is another option. By overpaying your mortgage now you can do a number of clever things. Firstly you reduce your mortgage interest and term as explained in Pay off your mortgage 9 years early.

Plus, by reducing your debt more quickly now, you will owe less in real terms and as a proportion of your property's value. The bigger this 'equity buffer' the more competitive deals will become available to you if you do decide to switch later on.

Also, if you face payment problems in the future as a result of rising rates, the fact that you have overpaid and built a buffer would stand you in good stead with your lender.

If don't want to tie up your money in your mortgage, you could save your excess cash into a separate savings account. At least with an instant-access account, you can get your hands on your money quickly if you need it.

Whatever you decide when you come to the end of a mortgage deal, make sure you understand not only the alternatives but also what could happen if interest rates go up. By planning for this eventuality you can make the most of low rates with one eye on the future.

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