How BOE Base Rate Hikes Show the Risks of Variable Interest Rates
If you have a mortgage in the UK, you might be seeing an increase to your monthly payment. Again. The latest rise in the UK interest rate to 2.25% is one more increase in a pattern that’s becoming painfully familiar to Brits across the UK.
But why are monthly payments increasing? The answer comes down to variable interest rates. Here, we’ll take a closer look at just what variable interest rates are, why they can be risky, and how you can stay prepared as more interest rate hikes loom on the horizon.
What is a Variable Interest Rate?
A variable interest rate is a type of interest rate that’s based on a benchmark measurement such as the Bank of England (BOE) base rate. Depending on market conditions, the BOE base rate will change, and that change will be reflected in variable interest rates seen on credit cards, loans, and commonly on mortgages.
Related: How Different Types of Interest Impact Your Credit
Why Are Variable Interest Rates So Risky?
Variable interest rates are the most common type of interest rate in the UK, and for credit products like mortgages and credit cards, and they’re often lower than fixed interest rates. But that reward doesn’t come without risk.
With variable interest rates, you may be unable to predict how much your interest rate will change over time. Banks will typically increase their variable rate if their funding costs go up, as we’re seeing now with the Bank of England raising its base rate to 2.25%.
How Does a BOE Base Rate Hike Impact Variable Interest Rates?
To illustrate how an increase to the BOE’s base rate impacts variable interest rates, let’s say you have a 25-year tracker mortgage for a £250,000 home. With tracker mortgages, your interest rate is directly tied to the BOE base rate, so when interest rates went from 1.25% to 1.75%, your monthly payment would have increased from approximately £970 to £1,029.
Following the 22 September base-rate increase from 1.75% to 2.25%, your tracker mortgage would have a monthly payment of £1,090, reflecting over £100 in increases since August.
Are Fixed Interest Rates Less Risky?
Fixed interest rates are less risky, but that alone doesn’t tell the full story. Fixed interest rates tend to be more expensive than variable interest rates. To understand why that is, it helps to be aware of the factors that influence those costs, and that’s primarily the risk that lenders take on.
With a fixed interest rate, lenders are exposed to more risk. On the other hand, a variable interest rate passes most of the risk on to you as the consumer because banks retain the ability to raise and lower the interest rate as the economy reacts to things like BOE base rate changes.
Which is Better for Me: A Fixed or Variable Interest Rate?
It ultimately depends on your stomach for risk and your budget. A variable interest rate may cost you less in the long run, but it could also expose you to periods of instability. On the other hand, a fixed rate may cost you more, but can also provide some peace of mind and stability in terms of your monthly budget.
Determining which is best for you will also depend on your credit score. If you have low or no credit, it might be difficult to obtain a favourable fixed-interest rate, and a variable-rate mortgage might be more attainable.
Even if you decide a fixed-rate mortgage is best for you, it’s important to account for how you’ll stay prepared if your payments change from month to month. While fixed-rate mortgages typically have initial terms lasting between 2-10 years, you need to be prepared when that period ends.
Right now, about 3 million Brits have fixed-rate mortgages that will expire within the next two years. With interest rates expected to rise as high as 6% by summer 2023, many people with fixed interest rates will see an increase in monthly payments when their initial terms expire.
How to Stay Prepared as Interest Rates Rise
The Bank of England’s raises to the base interest rate can have a profound impact on your monthly finances. When your money isn’t going as far as it did a year ago due the UK’s high inflation rate, a higher mortgage payment on top can make money tight. To stay prepared during a recession, make sure that you do the following:
- Build an emergency fund: Not only will an emergency fund with three to six months of living expenses help protect you in the event you’re laid off due to the recession, it can also help you stay on top of payments if you fall behind.
- Focus on making timely payments: Missed payments have a huge impact on your credit score. By making timely payments, you’ll protect your credit score and make you available for more favourable interest rates.
- Make and follow a budget: It’s not glamorous, but budgeting is essential, and getting clear on where you money is going can help you find areas that you can cut back in order to prepare for potential increases to your mortgage payments.
Build Your Credit to Get the Best Interest Rates
Whether you have a mortgage now or are looking into getting one for a home, your credit score will play a large role in helping you secure the best mortgage rate. But building your credit score is no easy task—which is why we created the Pave app.
Pave helps you build credit by staying on top of your monthly payments with bills monitoring, actively building your credit by reporting timely payments to credit reference agencies, and giving you personalised credit fixes.
Our tools help take the guesswork out of credit building and empower you to take your finances further. To learn more, download the Pave app from the App Store or Google Play today.