Why you need a mortgage buffer zone

Mortgage rates are at historic lows, and for homebuyers it looks like the perfect opportunity. But in your eagerness to secure your dream home, you should be wary of ‘mortgage shock’ – the danger of over-stretching yourself in the longer term. The solution? A borrowing buffer zone. Article by Nick Green.

The question everyone’s asking is: how low can they go? Since the 2008 financial crisis, interest rates have seen cut after cut, delighting borrowers and disappointing savers respectively. At times it seems like the boy band One Direction was named after them.

But, as keen observers will have spotted, there is a limit. Rates are now hovering just above zero per cent. In theory they could go negative, as happened in Japan, but it’s unlikely that Bank of England governor Mark Carney would want to do that (at it would mean you’d have to pay to keep your savings in the bank).

This leaves us with two possibilities. One, interest rates will stay more or less the same for years and years – in which case we can more or less kiss goodbye the idea of earning interest on our savings. The other option is that rates will have to start rising again. This is great news if you’re a saver – but could potentially cause mortgage holders big problems.

The only way is up, baby

If you look at it just in terms of mortgage rates, homebuyers have never had it so good. Not long ago the Coventry Building Society launched a 10-year fixed rate deal of just 2.39 per cent, the lowest such rate in history, and other lenders soon followed suit. Of course, the downside of cheap borrowing is that house prices soar as a result, so you as a homebuyer may not feel that much benefit.

First-time buyers and upsizers alike have to scrabble around for every penny, and the traditional wisdom is that you should push yourself to the limit when buying a home because hey, it’s an investment. (The other reason is that the whole process is so grisly that you won’t want to face it again for at least a decade.)

But there’s a problem. Borrowers are now backed into a corner: interest rates are now (probably) as low as they will ever be. They have nowhere left to go but up. On the one hand, this may be an incentive to grab the best mortgage you can right now. On the other hand, it means you face the prospect of paying very much more in interest when your current fixed rate expires.

How likely are rate rises?

The short answer is that no-one seems to know. It was once predicted that a Brexit vote would result in interest rates going up, due to property in the UK becoming less desirable, but the response from Carney was yet another cut to calm the waters. But it remains unclear what will happen when (or if) the UK does finally leave the EU, as the emergency measure of cutting interest rates is no longer available - they're as low as they can go. The likely trend in years to come, therefore, is almost certain to be a series of small rises.

What would rate rises mean for homebuyers?

Interest rates have been much higher in the past, of course – in the 1990s they hit a mythical-sounding 15 per cent – and homebuyers have comfortably rubbed along with rates of around 5 or 6 per cent. But there’s a big difference to bear in mind: those people didn’t take out their mortgages when rates were 10 or 12 times lower.

For example, if you were to take out a £100,000 mortgage now over 20 years, and could (let’s say) secure an average 3 per cent interest rate for the whole period, your monthly repayments would be £555. However, if you took out the same mortgage with an average 6 per cent interest rate, your repayments would be £717 a month. That difference of £162 may not seem like much, but if you had already stretched yourself to the limit to obtain the best property you could, it could easily push you from the black into the red.

Project Prudence?

The Bank of England governor has explicitly warned prospective buyers of what he calls ‘mortgage shock’. Carney said, ‘We are advising people to be prudent. If you are taking out a mortgage, at some stage, during the life of that mortgage, conditions will be difficult.’ He warned not just of interest rate rises but of other factors that could hinder people’s ability to repay their loans, including turmoil in the jobs market, possible wage reductions and other uncertainties.

Carney made it very clear he was not discouraging buyers at this time – rather, he was encouraging them to think long-term and to allow for the inevitable changes that would happen over the lifetime of their mortgage.

Sorting out a mortgage ‘buffer zone’

The smart guidance now (and, indeed, at any time) is to take out a mortgage that you can comfortably afford – and could still afford in the future if some circumstances were to change.

For example:

1. Find out what your mortgage repayments would be if your current interest rate were to go up by three percentage points, and see if you could still afford it.
2. Now take a look at your savings, and work out how long you could keep up repayments on your current rate) if you, your partner or both of you were to lose your jobs.
3. Finally, do the calculation for point 2 again, this time using the higher interest rate from point 1.

If any of the scenarios result in you instantly being unable to afford your mortgage repayments, then seriously consider taking out a smaller loan that you can afford in these circumstances.

Do the sums, then find the deal

The above examples are highly simplified – the real mortgage process involves many more factors, including fixed rates, tracker rates and deals of various lengths, exit charges, arrangement fees and the lender’s standard variable rates. It can all get very complex very quickly, so that what looked like a very good deal at the start can turn out to be far more expensive in the long run. Amid the general stress of the home-buying process, it can be a very difficult thing to handle by yourself.

An independent financial adviser or mortgage broker can handle this entire process for you. Talk to your adviser about ensuring that your mortgage is affordable in the long term, even if your circumstances alter somewhat. You can also test your mortgage readiness using our free mortgage checker.