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The steps you can take ahead of an increase in borrowing costs
Thursday 11 Nov 2021 Author: Laith Khalaf

The Bank of England surprised markets by keeping interest rates on hold at 0.1% on 4 November but says it will probably hike rates in the coming months.

Beyond that, more interest rate rises almost certainly lie in store, though they might be slow and steady. The Bank won’t want to put too much pressure on the economy, and thinks inflation is going to be a flash in the pan, even though it’s expected to peak at 5% next April.

Although the pace of tightening monetary policy is going to be glacial, a sustained rise in interest rates would be a tectonic shift from the low interest rate environment we’ve seen since the global financial crisis in 2008.

There have only been two interest rate rises in the last 14 years, and based on ONS data, AJ Bell estimates around 10 million people in the UK haven’t seen interest rates above 1% in their adult lives. Inevitably we have all become accustomed to extremely cheap borrowing costs, so when they arrive, higher interest rates might well come as a bit of a shock to the system.

But there are some concrete steps you can take ahead of any rate rise, to minimise the financial pinch you feel when the Bank of England finally lurches into action.

FIX YOUR MORTGAGE

Anyone on a variable rate mortgage will see their interest rates go up overnight if the Bank of England raises rates. However, if you are in a position to fix your mortgage now, you’ll lock in current low rates, and avoid the effect of interest rate rises until your fixed rate period comes to an end.

Mortgage companies have already started to increase their rates, and they’ll probably bump up again, once a rate rise actually happens. Someone with £250,000 of borrowing on the average variable rate mortgage rate of 2.45% could save £2,088 a year by switching to the current top two-year fix.

If rates rise to 0.25% they would save £2,316 a year (figures based on a repayment mortgage with a 25 year term and 80% loan-to-value). If you lock in for an even longer period, then you’d save less each year, but potentially more over the term of the fix. Most people re-mortgaging recently have been buying fixed rate deals, because they’re really cheap, and give you good visibility over your monthly outgoings.

DON’T FIX ALL OF YOUR SAVINGS

While a rate rise is slightly positive news for savers, who’ve suffered more than 12 years of ultra-loose monetary policy, buying a fixed rate now means you’ll miss out on any increases. The top two-year fixed rate account is currently paying 1.76%, which is significantly more tempting than the top easy-access account of 0.65%.

But both those rates should increase if the Bank of England raises the Base Rate – and if you’ve already locked in for two years at today’s rate, you won’t be able to switch without penalties. There is a really delicate balance to strike here, because the longer you sit in an easy access account, waiting for interest rate rises to come along, the more you miss out on the extra interest you could have earned by fixing.

There’s no easy answer to this conundrum, beyond spreading your cash around between fixed rate savings and easy access accounts. That hedges your bets, giving you some flexibility for the future, and some extra interest today.

SHOP AROUND WITH YOUR CASH

The supermodel Linda Evangelista is famous for saying that she didn’t get out of bed for less than $10,000 a day. Cash savers will perhaps (partly) empathise with this, as interest rates have been so measly, it hardly seems worth getting out from under the covers to shop around for a better rate.

The good news is that rising rates will mean greater rewards for those who seek out the best deals. The bad news is that some accounts won’t pass on the benefits of rising rates quickly, if at all, so those who don’t shop around might well miss out.

Interest rate rises mean it’s time to get out of bed, and start sniffing around for the best deals for your cash.

SORT YOUR DEBT

Anyone with debt is going to really feel the pinch of an interest rate rise, as the interest they pay each month will increase. Banks are very quick to pass on any rate rise to customers when it suits them, so those with debt should be braced for higher costs straight away. This will probably be compounded by rising inflation and higher taxes, putting pressure on household budgets.

Anyone with debt needs to work out if they can switch to cheaper borrowing, before rate rises start taking their toll. Look at whether you can take advantage of a 0% balance transfer deal on your credit card, or if you might be eligible for an interest-free overdraft.

If you have money to pay down some of your borrowing, start with the most expensive first, as that will free up more of your disposable income to come back for another swipe at your debt pile.

CONSIDER INVESTING YOUR MONEY

Even with interest rates rising, if savings rates increase by the same amount as the Bank of England’s base rate you’ll still be nowhere near beating inflation. The current top easy-access savings account pays 0.65% interest. If the base rate rises from 0.1% to 0.25% and all of that increase gets passed on to savers, then the top account will pay 0.8%.

That’s still miles below current inflation of 3.1% and even further away from the 5% inflation expected next year. Cash is a great place for money you might need quick access to, but for long-term savings it’s very likely to lose its buying power.

So, work out what you need in the next five years, or as an emergency pot, and see how that stacks up against the amount you’ve got in cash. If you’ve got way more than that set aside, think about investing the excess in a Stocks & Shares ISA, to shelter it from tax.

The Bank of England has made it clear an interest rate rise is on the way. For some time to come though, borrowing will still be cheap by historical standards, and on the flip side, savings rates will be low.

Rate rises will be gradual, so there’s no need to panic. But interest rate policy is a little bit like the tide, slow and powerful, so it’s best not to leave it too long until you shore up your finances.

DISCLAIMER: Financial services company AJ Bell referenced in this article owns Shares magazine. Tom Sieber who edited this article owns shares in AJ Bell.

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