Archive for February, 2010
Written by Adam Diver on Wednesday, February 24th, 2010 in Personal Finance.
It would be impossible to miss the news on the Fed’s interest rate cuts, pushing them down to a historical rate of between 0 and 0.25%, resulting in the cost of borrowing being the cheapest it has been in living memory. However, what we really want to know is, how does this change affect us? Most people’s biggest sum of debt comes from their mortgages, so the biggest effect a change in the Federal Reserve’s interest rate is most likely that of a change in the size of mortgage repayments. It is important to understand what type of mortgage you are on before you can consider what effect the change will have on your repayments.
If you are on a fixed rate mortgage, no matter what happens to the Fed’s interest rate, your mortgage repayments won’t change. This is because you have signed an agreement with your bank to pay a certain rate of interest on your mortgage.
Things get more interesting when you are on a tracker or variable rate mortgage. These mortgages generally follow the interest rates set by the Fed so if the Fed reduces their interest rate, your payments should go down, or if the Fed increases their rate, your payments should go up. Most tracker mortgages will state how closely they track the Fed’s rate, for example you may be on a mortgage that tracks 1% above the Fed’s rate, so if the rate was 0.25%, you would be paying 1.25% interest on your mortgage. If the rate increases, so will the size of your mortgage repayments. One thing to watch out for, which has caught a lot of people out on tracker mortgages over the last 12 months, is a collar clause. This is a loophole in the mortgage contract that states that a tracker mortgage will only track the Fed’s interest rate to a certain extent, so if the rate drops to 0.5% and your mortgage tracks at 1% above the base rate, you would expect to pay 1.5% on your mortgage. With a collar-clause in place, your mortgage interest rate may not go down below 3.5%, for example.
If you are taking out a new mortgage, and hoping to take advantage of the Fed’s low interest rate, you will be disappointed to find that many banks haven’t passed this rate on to the consumer. This is because banks are pricing for the extra ‘risk’ of lending in this harsh economic climate; the banks may fear for you losing your job and thus not being able to repay your mortgage so bump up their interest rates. This is known as a lack of the availability of credit, which has been recently referred to as the ‘credit crunch’. However, it might be worth waiting for more favorable rates as the economic climate seems to be improving, and credit terms should become looser in the coming months.
To briefly summarize this article, if you are on a fixed rate mortgage you won’t feel the difference from a change in interest rate made by the Federal Reserve. If you’re on a tracker or variable rate mortgage the size of your mortgage repayments should follow the Fed’s interest rate to some degree, but be wary of collar clauses! And, finally, if you are on the lookout for a new mortgage, be aware that you will struggle to find a mortgage an interest rate that is anywhere near the base rate and you may wish to consider putting off your search until credit terms have loosened in a few months.