Getting the lowdown on interest rate rises


Homeowners on variable interest rates are in line for a rate hike of as much as 1.5 per cent, writes FIONA REDDAN

HOMEOWNERS ARE bracing themselves for the latest assault on their finances, as lenders prepare to hike interest rates on variable-rate mortgages.

Last year, the crisis facing many mortgage holders, given the downward pressure on interest rates, was how to get out of a fixed-rate mortgage without incurring sizeable breakage fees. Now, however, those who locked in at a reasonable level over the past few years may feel that it wasn’t such a bad idea. Those on variable rates are in line for rate hikes of as much as 1.5 per cent, which would add an extra €300 a month to the average mortgage in Dublin.

Why are rates increasing?

Variable interest rates go up and down over the life of the mortgage at the behest of the lender. Typically, they will increase in line with interest rates set by the European Central Bank (ECB), but lenders may not always pass on ECB rate cuts.

The current situation is notable because, while the ECB rate remains at a record low of just 1 per cent and is not expected to rise until the end of the year, variable rates are nevertheless likely to rise, thereby going against the overall interest-rate trend.

The reason for this is that the banks, hammered by the financial crisis, have to find ways of increasing their profitability and absorbing ongoing losses. One way of doing so is by improving their margins on commonly used financial products such as mortgages.

Foreign banks operating in Ireland made the move some time ago, effectively closing themselves to new business in the process, and now it is the turn of the domestic lenders.

Last summer, Permanent TSB increased its standard variable rate for existing customers by half a percentage point, hitting 50,000 homeowners in the process. At the time, however, the other domestic institutions were in a tricky political situation, given their reliance on the Government to get the National Asset Management Agency (Nama) up and running. No one followed Permanent TSB’s move.

This time around things are different, with Nama almost operational and banks more anxious then ever to improve their margins.

Karl Deeter, operations manager with Irish Mortgage Brokers, expects EBS and Permanent TSB to lead the charge, followed by the foreign banks and, further down the line, by the two major domestic lenders, AIB and Bank of Ireland. “It’s an ideal time to raise margins, when interest rates are low,” he says, explaining that customers may be able to absorb increases better at the moment than they would when interest rates are higher.

How many people would a rate hike affect?

According to the Central Bank, as of last June, 84 per cent (by value) of private residential mortgages in Ireland were at a variable rate, with 16 per cent at a fixed rate.

Given that there are roughly 800,000 such mortgages in Ireland, a rough estimate indicates that 672,000 people are on variable-rate mortgages and 128,000 are on fixed rates.

However, not all of these 672,000 people will be affected, as this figure also includes those on tracker mortgages, which are set by reference to the ECB rate and do not allow lenders to increase their margin.

A move to higher margins on variable rates will not leave all fixed-rate mortgage holders unscathed. Up to 63,300 such mortgages – roughly half of all fixed-rate loans – are fixed for between one and three years, according to Central Bank figures, so they may be hit by higher variable rates when their fixed term ends.

According to Frank Conway, a director with Irish Mortgage Corporation, the demographic most likely to be affected by a rate increase is first-time buyers who acquired their homes in the past 18 months.

He says there are, in general, two distinct groups of people on variable-rate mortgages: those who bought before the boom and the introduction of tracker mortgages, and those who have bought in the past 18 months, when trackers were no longer available.

While the first group will not be that badly affected by the rate increase, given that they are likely to have smaller mortgages relative to their income and a lower loan-to-value (LTV) ratio, the second group will find it tough.

According to Conway, a rate hike could be the tipping point for some people, given that they may also be dealing with negative equity and negative income.

How will a rate increase affect me?

Deeter estimates the impending increase in variable rates to be about one percentage point, spread throughout 2010, but some say it could be as high as 1.5 per cent. If the higher increase is imposed, this will open a significant gap between the ECB rate (1 per cent) and a variable-rate Irish mortgage (4.1 per cent) – given that the average standard variable rate at the moment is about 2.6 per cent.

When you factor in that the ECB will eventually have to increase rates – although perhaps not until 2011 – those on variable-rate mortgages can expect even more pain. Once the banks have increased rates, they will be slow to bring them down again.

Conway says a rule of thumb is that a 0.25 per cent increase will add about 3 per cent to the cost of a monthly repayment, a 0.5 per cent increase 6 to 7 per cent, and a 1 per cent hike 10 per cent. So, based on a monthly repayment of €1,000, you could expect this to increase by €30, €60 or €100 a month, respectively, depending on the possible rate increase.

More specifically, take the example of the average price paid for a property in December 2006, which was €427,343 in Dublin and €266,339 for the rest of the State, according to an Economic and Social Research Institute/Permanent TSB survey. Based on a 90 per cent borrowing, the average size of mortgages in this example is about €384,608.70 and €239,705 respectively.

If the variable rate rises by 1 percentage point, the homeowner in Dublin can expect to fork out an extra €200 a month servicing their mortgage, while the person living in Tipperary will need to pay an additional €130 each month. These are significant sums when taken in the context of falling incomes and a raised tax burden.

Will the Government intervene?

If the banks go through with the planned rate hikes, there may be a public outcry similar to that led by homeowners seeking to get out of fixed-rate mortgages last year. However, it is likely that the response from the authorities will be the same.

While the taxpayer now has sizeable shareholdings in both AIB and Bank of Ireland, it is unlikely that the Government would intervene to prevent the banks from raising variable rates. Given the banks’ precarious positions, a return to profitability is seen as essential for the Government to be able to sell its stakes in the banks, and for the taxpayer to exit the banking sector.

With deposit rates still high and margins on borrowing low, banks have to find a way to make money.

“If the banks aren’t making money on transactions, it has to come from somewhere – either from the taxpayer or the borrower,” says Deeter.

How about switching to a cheaper lender?

If the rate hike does come to pass, your first instinct might be to scan variable and fixed rates on offer with other institutions and seek to switch over to the cheapest.

However, this is easier said than done, with banks tightening up their lending practices all round and some not even in the market for remortgaging.

Firstly, you will need an LTV of no more than 92 per cent, and preferably less, to be considered by the two main domestic banks. Other banks impose even stricter ratios.

Moreover, to get the best rates on offer, you will really need a much lower LTV, as banks seek to cherrypick customers by offering the best rates to those it considers the lowest risk. For example, Bank of Ireland has a variable rate of 2.3 per cent for those with an LTV of less than 50 per cent, while AIB offers 2.25 per cent for the same LTV.

If you are able to switch, you may want to make your move sooner rather than later, as banks are likely to increase the fixed rates they offer at the same time as they raise variable rates.

Both AIB and Bank of Ireland currently have some of the best fixed rates available, with AIB offering 2.8 per cent fixed for two years, rising to 4.65 per cent if you want to fix for 10 years.

However, banks are offering existing customers less attractive rates than new ones. Bank of Ireland has a five-year fixed rate of 3.3 per cent for new customers, but existing customers will be charged 3.5 per cent.

What happens if I’m in negative equity?

Unfortunately for those in negative equity, the high LTVs required by lenders these days mean that options will be limited. As Deeter says, “you’re stuck”.

With those who bought at the peak of the market possibly having LTVs of as much as 150 per cent, depending on how much they put into the purchase themselves, no bank is going to want to take on this risk.

For example, if you bought a property for €475,000 on a 100 per cent mortgage in 2007 and now find that it is only worth about €325,000, you have an LTV of 146 per cent. Until this LTV comes back down to a level closer to 90 per cent, you will have to stick with your current lender and accept whatever rates it decides to impose. For some people, the one saving grace is that they are on a tracker mortgage.

While waiting for property values to rise again, you could try paying down your mortgage by as much as you can afford, thereby reducing your LTV.

I’m on a tracker, so I’m not affected, right?

If you took out a tracker mortgage during the boom, when banks were offering rates as good as the ECB rate plus 0.5 per cent (which today equates to an interest rate of just 1.5 per cent), you may be feeling smug and unconcerned about the proposed rate hikes.

However, before you turn the page, you should consider how the increasingly expensive mortgage market might affect you.

Firstly, some banks only offered discounted trackers for a certain period, after which customers have to switch to variable or fixed. And like homeowners on variable or fixed rates, even those on tracker rates are captive to their lender, but perhaps to a lesser extent.

While you may not be considering remortgaging given your more competitive mortgage, what happens if you wish to buy a new house? Or release equity? Or switch to interest only? You can be sure that if any changes are needed, your bank will avail of the opportunity to take you off a tracker.

Finally, one scenario which Deeter says might emerge is that banks, desperate to get rid of expensive trackers, request a revaluation of homeowners’ properties. So if you got your tracker on the basis that you had an LTV of 80 per cent, the bank could rescind it as, given the decline in house prices, your LTV is now closer to 100 per cent, and therefore you might no longer qualify for the rate.