Living on borrowed time

Improvements to public services may not be the only compensation from the higher taxes the Chancellor will announce in his Budget on Wednesday. Homeowners may also be spared steep rises in mortgage rates.

Higher taxes, through increased national insurance payments or increases in duties and other indirect taxes, will still leave wage earners poorer. But higher taxation could dampen enthusiasm for home improvements, shopping and eating out, reducing the need for hikes in interest rates, despite the fact that house prices are rising at more than 15 per cent a year.

This month the Bank of England again left the base rate untouched at 4 per cent for the fourth month in a row. Last week, Bank of England Governor Sir Edward George seemed to dampen expectations of an early rise in rates - some economists have forecast a May move - when he said consumer spending might moderate of its own accord. But borrowers cannot afford to assume they will escape increased rates over coming months. Economists at stockbroker Gerrard believe the bank base rate will rise to 4.25 per cent by the end of this year and to 5 per cent by the end of next year.

For homeowners who lived through the early Nineties, when mortgage rates topped 15 per cent, this seems like small beer. But a new generation of borrowers has joined the housing market since then; a 1 per cent rise in mortgage rates could add £55 to the cost of a loan to purchase the average-priced property, according to calculations by Nationwide building society (table, page 4).

The Gerrard forecast is at the lower end of City expectations and significantly lower than the levels being assumed by the financial futures markets, which are pointing to rates as high as 5.5 per cent by the end of this year. That could lift mortgage payments on a £92,000 loan by more than £80 a month. A more common prediction among analysts is for rates to rise to 4.5 per cent by the end of this year, starting in August.

Rates will go up to keep a check on inflation by deterring people from over-spending and over-borrowing. Homeowners borrowed a record £7 billion against their homes in the last three months of 2001, the highest figure on record and significantly more than the levels reached in the late Eighties. Nearly half of mortgage-related borrowing in the final quarter of last year was for purposes other than purchasing a house. Consumers borrowed nearly £2 billion on credit cards and other forms of unsecured consumer credit in the final quarter of last year.

Simon Rubinsohn, chief economist at Gerrard, says that, measured as a share of disposable income, our mounting levels of debt are less dramatic than they first appear. Rubinsohn draws comfort from that fact that in the fourth quarter of last year the proportion of disposable household income taken up by interest payments dropped to little more than 7.5 per cent, one of the lowest levels seen for several years. This is largely due to the falling cost of borrowing.

Jonathan Loynes at Capital Economics is unconvinced about our ability to withstand an interest rate shock. Borrowers are suffering a form of 'money illusion' at present because they have failed to appreciate the impact of low inflation on debt, he says.

'The average household is spending 8 per cent of income on servicing debt, which is half where we got to in the late Eighties consumer boom.

'The beneficial effect of low inflation is that now interest rates are very low, but debt is not eroded as in previous decades. When inflation was higher, people were quite happy taking out mortgages worth 50 per cent of income because they knew that in five or 10 years' time that proportion would have dropped,' he says. 'Inflation did a lot of this work for us. People see the benefit of low inflation but perhaps don't fully understand that high debt is here to stay. I am getting increasingly concerned about it.'

This could make borrowers more sensitive to even small increases in borrowing costs than in the past.

Homeowners may not face the crisis suffered by borrowers in the early Nineties, but they could still face a slow-burning threat from prolonged spending on large debts.

Patrick Bunton of mortgage broker London & Country says that anyone stretching to afford a move now should be looking for a fixed or capped-rate deal. Borrowers may resist this because fixed rates are already around 1 per cent higher than variable-rate loans, reflecting expectations in the money markets of higher loan rates to come.

It may be tempting to go for the option that appears the cheapest, but this could prove to be a mistake in the long term.

Borrowers taking out attractive-looking short-term deals need to look carefully at the standard rate charged by their lender, particularly if the deal ties the borrower into that rate for a lengthy term after the expiry of the fix. Borrowers should also consider whether the lender's standard rate is higher now than that of competitors.

Northern Rock bank's standard rate is 5.85 per cent, compared with Nationwide's 4.94 per cent, and Northern Rock is currently offering a two-year fixed deal at 2.89 per cent for two years. At that point the loan rate reverts to the standard rate. A £100,000 loan would cost £472 at 2.89 per cent, but payments would rise to £642, assuming today's rates still prevailed at the end of two years. The bank says it gives clear warnings about the potential cost increase.

Borrowers should ask lenders to quote payments at significantly higher levels than on today's deals, to see how affordable the loan would be. Bunton says: 'If 8 per cent is affordable, you can feel pretty confident.'

Overextended?

Thirty-one per cent of people who remortgaged last year took advantage of house price increases to take out larger loans. Drawing equity out of your property makes sense if you are planning work that will add to its value, such as a loft extension or central heating, or if you have built up expensive credit card debts that are incurring a much higher rate of interest.

But there are two important things to remember. First, mortgage debt may have a lower interest rate, but it is usually paid off over a much longer period, so adding credit card debts on to your mortgage could actually cost you more in the long term, unless you make a special effort to overpay and cancel the debt quickly.

Second, if your mortgage already represents a large proportion of your home's current value - say 85 or 90 per cent - you would be wise to put off extending your loan. Otherwise you could find yourself trapped by negative equity.

The more 'yes' answers you give, the worse your chances of coping when borrowing costs rise.

Higher rates: how well will you cope?

Do you have a variable rate loan?

Fixed rates are not always as cheap as variable deals with discounts, but they provide certainty if your finances are stretched.

Did you push your budget to the limit to afford your property, perhaps borrowing the deposit as well?

In the past, hefty salary rises would have reduced your mortgage burden within a year or two of you taking it out. But unless you're a whizz kid, your salary will have done little more than keep pace with inflation. Prepare to tighten your belt.

Do you think budgeting is for bores?

One positive aspect of the struggle many first-time buyers have, to get on the property ladder, is that it forces them to start balancing their own books. If you managed to buy without a budget, you're probably rich enough not to worry.

Are you locked into a variable rate deal that automatically raises payments once the special rate has expired?

Lenders do not offer these deals as freely as they once did because there was an outcry from unhappy borrowers. But they are still available; responsible lenders will make sure you know what you can expect once the special deal expires. Make sure you listen.

Do you have several debts as well as a mortgage?

No explanation needed here; more is not merrier with multiple debts.

Have you borrowed to pay off other debt?

Not necessarily a bad idea if you have cut monthly outgoings and have resisted any temptation to continue borrowing.

Is your loan large in relation to the value of your property?

You're at risk of negative equity if the housing market collapses. This does not mean you will have trouble with repayments, but it will be hard to sell your way out of trouble.

Do you have a second mortgage?

Again, not a problem necessarily, but an indicator that you could be overstretched and underinformed about the cost of credit. Ray Boulger, of mortgage broker John Charcol, believes that many people take out expensive second mortgages to raise funds when they could probably borrow from their existing lender.

The rate on a second mortgage may be lower than on a credit card, but it may not be as low as if you borrowed from a mainstream lender. When you take out a second mortgage, you increase the risk of losing your home if you cannot keep up the payments.

Do you think shopping around for loans and credit cards is a waste of time?

At present it is possible to switch debts from an existing credit card to a new one and pay no interest for several months on the debt you transfer. The trick then is to move on to another zero-rate or low-rate deal when this one expires.

If you have a traditional variable-rate mortgage, you are almost certainly paying more than you need. There are many deals available at less than 5 per cent, without onerous extended redemption penalties.