How low can interest rates go?

Published 08th Nov 2008

We look at predictions that the base rate could hit record lows in the next year


Economists are predicting that interest rates will tumble to a record low in the next year. The Bank of England cut the base rate by one and a half percentage points to 3 per cent on Thursday, but the expectation is that it will fall even further as the UK economy plunges into recession.

One in three people expects the base rate to drop to 2 per cent, or less, according to a survey by Fool.co.uk, the financial website - a view echoed by City experts. HSBC expects it to be at 2 per cent by the middle of next year. Jonathan Loynes, chief European economist at Capital Economics, the research consultancy, is plumping for 1 per cent. Some reckon that even zero per cent is a possibility.

Such lows would be uncharted territory for the UK. The base rate has not been near such levels since 1951, when it stood at 2 per cent. The most recent low point was a cut to 3.5 per cent in 2003.

Here we explain what such a dramatic drop in interest rates will mean for your finances.


Borrowers

Cuts in the Bank of England base rate would usually be cause for celebration, but with the financial crisis still in full swing, borrowers may not feel the full benefit of aggressive rate cuts this time around.

Lloyds TSB, Cheltenham & Gloucester and Abbey were the only lenders to reduce their standard variable rate (SVR) on Thursday, by the full 1.5 percentage points. Other lenders failed to act, saying that their SVRs would remain under review. Meanwhile, almost every major lender except HBSC pulled their tracker deals, which are pegged to the base rate, preventing new customers from benefiting from the cut. Earlier in the week a number of lenders, including Abbey and Woolwich, had increased their tracker rates in expectation that the base rate would fall but the extent of the reduction took them by surprise. Brokers expect most lenders to re-introduce tracker rates at higher rates in the coming days.

Andrew Montlake, of Cobalt Capital, the broker, says: “At the moment lenders are sticking two fingers up at the Government and steadfastly refusing to pass on rate cuts to customers.”

That does not mean that borrowers' repayments will not eventually fall. Interbank borrowing rates have dropped significantly. Three-month Libor, the rate used by banks to fund new mortgage lending, is at its lowest point since the collapse of Lehman Brothers in September. Another crucial money market indicator, two-year swap rates, is at a five-year low.

Advisers caution, however, that mortgage rates are unlikely to drop as much as borrowers had hoped. Ray Boulger, of John Charcol, the broker, says: “Tracker rates for new borrowers may begin to fall, but not nearly as far, or fast, as the base rate.”

Millions of borrowers already on tracker deals will expect their mortgage rates to fall in tandem with the base rate, but some of the biggest lenders prohibit rates from falling below a minimum threshold, or “collar”.

HBOS, the country's biggest mortgage lender, which is set to be taken over by Lloyds TSB, will not cut tracker rates if the base rate falls below 3 per cent. Nationwide, the second-biggest lender, will also refuse to pass on cuts if the base rate sinks lower than 2.75 per cent. David Hollingworth, of L&C Mortgages, another broker, says: “Borrowers must check the small print. Fortunately, some lenders, including C&G, Alliance & Leicester and Woolwich, do not restrict how far tracker rates can fall.”

If you are about to take out a new mortgage, advisers say that a tracker deal without a collar make sense. The best deals are still being reserved for borrowers with a big deposit, or a large amount of equity in their home.

Yesterday few lenders were still offering mortgages pegged to the base rate after banks and building societies scrambled to withdraw deals on Thursday. New trackers with higher rates are expected to be launched next week.

If you would prefer the certainty of a fixed rate, Abbey is offering a competitive two-year fix of 5.39 per cent for borrowers who can put up a deposit of at least 30 per cent.

Savers

The silver lining during the downturn has been a boom in savings rates, as banks and building societies have been desperate to shore up their balance sheets by attracting new deposits. However, financial experts believe that the latest base rate cut will bring this period of high returns to an end.

Kevin Mountford, of Moneysupermarket.com, the comparison website, says: “Savings rates will go into freefall over the next six months, not only because of base-rate cuts. The disappearance of the Icelandic banks and consolidation in the marketplace will mean that there are fewer banks competing to be in the best-buy tables.”

Instant-access accounts will drop sharply, according to Mr Mountford, falling at least in line with the base rate. Savvy savers should, therefore, move quickly to take advantage of the remaining fixed-rate deals promising returns of 6 per cent or more.

Abbey has a two-year bond fixed at 6 per cent. It is being pulled tomorrow night and replaced with a bond paying 5 per cent. But you can apply for the 6 per cent deal online before then. To keep tabs on the top deals, go to timesonline.co.uk/savings.

Investors

A sharp drop in interest rates would normally be good news for your share portfolio, because it would make it easier for business and individuals to borrow. But these are extraordinary times and most fund managers do not expect markets to profit, even if interest rates plummet.

Colin McLean, chief executive of SVM Asset Management, says: “I am less sure that rate cuts will make a difference as they have been well signalled and everyone is trying to pay off their debts, not borrow more.”

The general consensus is that it will be many months before the cuts will kick-start the economy out of the doldrums. Howard Wheeldon, senior strategist at BGC, the broker, says: “No matter how much interest rates are pushed down there will be no rush of consumers into the shops.”

The prospect of falling rates has already had a negative effect on the bond market. Paul Rayner, bond fund manager at Royal London Asset Management, says: “The price of a lot of UK government gilts already reflects the view that the base rate will fall to 2.5 per cent, which means that the yields on offer are extremely low.”

But he thinks there is good value in corporate bonds. Fears that many companies will be unable to repay bondholders has sent yields soaring to as much as 14 per cent. Mr Rayner thinks these fears are overblown.

Annuity returns set to fall drastically

Plunging share prices have wiped billions off pensions over the past 12 months. But for those approaching retirement, there is even worse news in that annuity rates are expected to be hammered by falling interest rates.

Advisers predict that annuity returns could fall by 10 per cent over the next 12 months. There are signs that the slide has already begun.

The insurers Canada Life, Legal & General and Norwich Union have all cut their rates over the past two weeks. The amount of annual income that a 60-year-old man with a pension of £100,000 can secure from Norwich Union has fallen by £60 over the past month, from £7,100 in October to £7,040 now.

When interest rates fall, this pushes down bond yields, one of the main influences on annuity rates. With the base rate predicted to drop to 2 per cent or less (see above) the drop in annuity rates is expected to be substantial by this time next year.

Tom McPhail, of Hargreaves Lansdown, the independent financial adviser (IFA), says: “With economic indicators now pointing downwards, we expect annuity rates to fall off quite sharply over the next year. The benchmark rate for a 65-year-old male is currently 7.7 per cent, and we think there is a strong argument for rates dropping well below 7 per cent.”

This will reverse the trend of the past 12 months, when annuity rates picked up and yields rose to their highest for six years.

This has been driven by a big jump in the yield on corporate bonds, the principal investment underlying many annuities, as investors have become extremely risk averse. As interest rates drop so will bond yields, forcing annuities to fall in tandem.

Advisers would usually be encouraging investors nearing retirement to lock in to annuities before rates fall, but the sharp drop in stock markets has complicated matters. Some investors approaching retirement will have suffered huge losses because their pensions were largely invested in shares. They might profit from delaying annuity purchase in the hope that their investments bounce back.

Once you have converted your pension into an annuity you are locked in for good, so it is vital to not make a hasty decision.

However, not everyone nearing pension age has suffered the full force of the downturn, having moved into less risky investments well before retirement. For them the decision is more clear cut.

Billy Burrows, of William Burrows Annuities, another IFA, says: “We do not believe that annuity rates will be cut drastically and quickly, but rates will drift down over the next few months. Those invested in cash, or other safe funds, may wish to consider purchasing their annuities sooner rather than later.”

Ensure that you shop around, as it can boost your income by as much as 15 per cent a year. Smokers and people in poor health receive the highest rates as they are likely to die sooner. Reliance Mutual recently raised its smokers' rate for a 60-year-old man with a £100,000 fund to £8,205, up from £8,024 last month.

Case Study: 'It was a huge relief when we read that rates would fall'

Philip Gates, 33, and his wife, Eilidh, 26, are moving out of a two-bedroom ex-council house in South Edinburgh and into a four-bedroom new-build home in Peebles, in the Scottish Borders, at the end of next month.

The couple, who have two children, were in the process of applying for a two-year fixed-rate deal when the Bank of England made its surprise half-point cut last month. This convinced them to opt for a tracker instead, securing a two-year deal from Cheltenham & Gloucester (C&G), at 0.89 percentage points above base rate. They have a 25 per cent deposit.

Mr Gates, left, who works as an IT security engineer, says: “We managed to get our tracker before C&G increased its margins, so we obtained a great deal. It was a huge relief when we read that rates were going to fall.”

They have opted for C&G's 2-Year All Weather Tracker Mortgage, which allows the couple to switch to a fixed rate at any point in their two-year term without having to pay an early redemption charge.

Mr Gates says: “The security of a fixed-rate deal is reassuring, as you know how much your outgoings will be. I hope that rates will fall across the board and we will be able to jump off our tracker and on to a three or five-year fixed-rate deal next year.”

He was pleased to hear that C&G does not have a collar on its tracker products, so rates will carry on falling in line with the base rate, even if it drops to 0 per cent. He says: “We really stretched ourselves with our new home, so anything that brings monthly savings is great news.”

The couple also managed to negotiate a good deal on the property, knocking down the asking price by 25 per cent. “I am not worried about falling house prices because we plan on staying here for a long time,” Mr Gates adds.

Source: ' times '

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