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How low could interest rates go?
By Rebecca Atkinson
The news that the Federal Reserve in the US has slashed interest rates by 0.50% to 1% has heightened expectations that the UK will follow suit and potentially bring interest rates down to similar levels. This has huge implications for both savers and borrowers.
Capital Economics, a firm of economists, says it expects the Bank of England's Monetary Policy Committee (MPC) to cut interest rates to an all-time low of 1% as a result of the credit crunch and the anticipated recession next year. It argues that "extraordinary circumstances require extraordinary actions".
Why are Interest Rates in the UK likely to fall?
Jonathan Loynes, chief European economist at Capital Economics, says: "Given that the UK's problems would seem to be at least as severe as those in the US, UK interest rates should arguably be close to US rates.
"Accordingly, we now expect UK interest rates to drop all the way to just 1% in this cycle, starting with a drop of 0.75% at next week's MPC meeting, if not before."
Loynes adds that it is not impossible to imagine the rates could fall even lower than 1%, perhaps even to zero.
MPC member David Blanchflower (who is an advocate of interest rate cuts) recently said the case for 'aggressive' rate cuts still stands.
"My view remains that interest rates do need to come down significantly and quickly," he added. "If rates are not cut aggressively we do face the prospect of a relatively deep and long-lasting recession."
When the next base rate cut will be remains to be seen. And the jury is still out on how big a cut will be seen this week. Stuart Thomson, chief economist at Resolution Asset Management, says: "We are confident that base rates will be reduced by at least 1.5% over the next six months and 2.5% over the next year. The next 0.5% cut is expected [this week], although once again we believe that this move should be 1%."
So, what do lower interest rates mean for households in the UK, from savers to mortgage borrowers?
Savers
If your savings account has a fixed rate, then you won't be directly affected. However, bear in mind that a climate of falling interest rates makes fixed deals look all the more attractive, and providers are likely to respond by cutting rates on new deals or by pulling existing bonds.
A lot of variable rate savings accounts come with Bank of England guarantees. These mean that although the rate tracks the base rate, it will not fall below a certain level. Opting for a savings account with this sort of guarantee should offer savers some security during the next year.
On the plus side, savers should remember that lower interest rates are designed to help the UK weather the recession.
In the current climate, many savers are opting for security and ease of access over rate. This is a tough trade-off, and it will depend on your own circumstances and confidence in British banks whether you go for fixed-rate (where any access could see penalised) or variable rate.
Borrowers
However, borrowers on a standard variable rate mortgage (SVR) might not be so lucky. Although SVRs should also rise and fall in line with the base rate, lenders do not have to pass on the benefits of lower rates - and many have recently indicated they are less than willing to do so.
Following October's 0.5% cut, only around 25% - 30% of lenders reduced their SVRs, with some passing on smaller reductions and the remainder not cutting rates at all.
This is bad news for borrowers. Pre-credit crunch, the advice to homeowners was never to sit on an SVR but instead remortgage to another fixed or tracker deal with the same lender or elsewhere. However, the current climate means that increasing numbers of people have now been forced to remain on their lenders' SVR, either because they are in negative equity as a result of house price falls or because their credit record makes then sub-prime and, therefore, higher risk in the eyes of banks.
There is another concern for borrowers with tracker mortgages. Lenders such as HBOS, Nationwide, Abbey and HSBC all impose minimum tracker rates, which means borrowers' rates will either never go below a certain level (normally 3%) or the bank will stop reducing the rate if the Bank of England's base rate falls below a certain level (again, normally 3%).
Ray Boulger, senior technical manager at John Charcol, explains: "Minimum tracker levels have only just emerged as an issue because previously the base rate wasn't expected to fall as low as economists now expect. However, banks that have these limits will stop passing on the benefit of lower interest rates at a certain point, which is bad news for many tracker borrowers."
And if you are a Halifax borrower, then a clause in its terms and conditions could pose even more problems for you down the line.
Halifax reserves the right not to pass on base rate falls below a certain level - 3% in this case. However, it is unique in the fact that it reserves the right to revert to the normal technique of pricing trackers and, therefore, increase the rate borrowers pay.
For example, if a tracker mortgage borrower pays Bank of England base rate plus 1%, and the base rate is 3%, then their pay rate will be 4%. If the base rate falls to 2% then Halifax does not have to pass on this 100 basis point saving, meaning the borrower continues to pay 4%.
If the base rate then rises back to 3%, Halifax reserves the right to increase the pay rate by a full percentage point - meaning the borrower's pay rate is now 5%. So, although their mortgage is base rate plus 1%, they are actually paying base rate, plus 2%.
If you are on a fixed-rate mortgage, then lower interest rates won't make an awful lot of difference to you immediately as your rate is guaranteed for a set period of time.
However, lower interest rates should help bring down rates on new mortgages, meaning that when it's time to remortgage, you should be able to find a decent deal.
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