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How lenders fund - and how do brokers explain it to clients?

Last month, the Bank of England increased interest rates once again to 2.25% - their highest level in 14 years.

But your clients won’t have failed to notice that the gap between the Bank of England base rate and fixed rates for mortgages is getting ever-wider, and of course, the fallout from the recent Mini Budget has added new uncertainties into the market.

The average two-year fixed rate had jumped to 5.97 per cent by Tuesday October 4th, according to Moneyfacts, up from 4.74 per cent on the day of Kwasi Kwarteng’s announcement on September 23rd. This means rates on two-year fixed deals are at their highest level in nearly 14 years - in the immediate aftermath of the financial crash.

So why are the rates being offered by lenders so different to the start of the year? And how do you explain to your clients exactly what’s going on?

Firstly, we should point out that the cost of borrowing has been historically low in the years since the financial crisis, and that’s led to lenders trying to price mortgages in a way that offers good value to borrowers, while keeping service levels high as the market evolves.

As a result, seeing mortgage rates changing and products being removed from the market isn’t, in itself, particularly unusual.

The difference between fixed rates for mortgages and the bank base rate is also down to how mortgage rates are funded.

A lender’s funding comes from various sources, including customers’ savings, government funding schemes and wholesale markets, which can change quickly depending on the wider economic context. For example, the ongoing war in Ukraine, the energy crisis and soaring inflation has profoundly impacted the environment in which the industry is operating over the last few months.

For fixed rates, lenders use swap rates, where - as the name suggests - two different parties swap interest rates. That means the price of a fixed rate mortgage is based on the price at which they can borrow in the swap market.

The bank base rate has gone up by 2.15 per cent over the last year, going up from 0.10 per cent to 2.25 per cent. But at the same time, two-year swap rates, which drive funding costs for fixed rate mortgages, have gone up by 5.10% (from 0.44% to 5.56% as of 26 September).

Swap rates reflect forecasts on what the Bank of England base rate may be in the near future, and with widespread expectations that interest rates will continue to climb, that’s directly impacting on the swap market.

But the increase in swap rates has changed the operating environment considerably, and lenders are under pressure to act quickly in response to fluctuations in the market.

As Jeremy Duncombe, managing director at Accord Mortgages, noted recently: “Daily increases of 30 basis points (0.30 per cent) are not unusual at the moment and following the chancellor’s Mini Budget (23 September), we actually saw a daily rise of 100 basis points (1.00 per cent).”

Simon Gammon, managing partner at Knight Frank Finance, observed: “Inflation is climbing rapidly and rates are going to rise as a result. Swap rates suggest that investors believe we're going to see a spike in costs and rates over the next 12 months to two years before markets start to normalise. That's likely why we're seeing this anomaly.”

The current inflation crisis is having widespread and unpredictable consequences - and mortgage rates are just one area where this is clearly visible.

So as you speak to your clients, many of whom will feel dismayed at the gap between the Bank of England base rate and mortgage rates, it could be important to provide this background and context.

Not only will this help understand why we are where we are, it could prepare the ground for the unpredictable future that lies ahead.

 

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