Should you fix your mortgage?

Keeping an eye on banks' new tracker rates may be a better option than some fixed rates, which often lack flexibility, writes Laura Slattery

Hindsight is a wonderful thing when it comes to fixing your interest rate. Back in the dim and distant days of November 2005, new homeowners could have "locked in" their mortgage rate for two years at fixed rates as low as 3.29 per cent.

At the time, this was a little bit higher than the typical "tracker" mortgage rates of 3.1 per cent offered by several lenders. But homeowners who opted for the cheaper, variable, tracker rate would since have seen it climb step by step up to a rate of 4.85 per cent.

At the outset, tracker mortgage customers would have been making lower repayments - €1,068 a month. Two rate hikes later, in March last year, the repayments would have overtaken those due on the fixed rate. By now, the tracker mortgage customer will be paying €1,319 each month.

The homeowner who opted for the two-year fixed rate is still only making monthly repayments of €1,094.

This €225 a month price for not locking in at the right time will increase even further if the governing council of the European Central Bank (ECB) goes ahead with its plan to increase interest rates again this summer.

So why didn't we all fix our mortgage interest rate before the ECB decided to start ratcheting up rates?

The problem with the fixed rate mortgages offered by banks and building societies is that they are riddled with catches: what seems like good value in the short term could eventually prove quite costly.

Borrowers who consider fixed rates are alarmed by the penalties charged on early redemption, according to Frank Conway, director at the Irish Mortgage Corporation, a broker firm that last year saw the proportion of buyers opting for fixed rates rise from 40 to 45 per cent.

The penalties prevent people from making lump sum overpayments and mean they will incur a charge if they need to move house and remortgage within the term of the fix.

"If you are going to be the beneficiary of lump sums such as a work bonus that you could use to pay off your mortgage, don't fix," advises Shane Connole, head of sales at IFG Mortgages.

Most people can't predict with certainty what their life and their finances will be like several years down the line, which is why longer-term fixes are rare.

Elsewhere in Europe, homeowners commonly fix their mortgage for 10 or 20 years, while last week a building society in the UK became the first major lender there to offer a 25-year fixed rate: homeowners can lock in their repayments as far ahead as the year 2032 if they feel like it.

But the greater the "unexpired term" on the fixed rate loan, the greater the redemption penalties.

"If you were to fix your rate for five years and move house next year, it will cost you more to break the fix than it would if you had opted for the three-year fix," explains Connole.

Longer-term fixes are also unpopular because, realistically, it is impossible to know which direction interest rates will take. The best five-year fixed rate at the moment is 4.89 per cent from First Active. This is roughly the same as the typical variable tracker rates charged to recent buyers.

But even if those tracker rates do spiral upwards this year, there is no guarantee that economic conditions won't trigger a fall in interest rates during the five-year term, leaving someone on a five-year fix with higher than average repayments over the period than someone who has opted for variable rates all along.

As a general rule, the people setting mortgage rates within the institutions will have a much better read on future interest rate direction than aspiring homeowners, and they will also be building in a profit margin for the bank or building society.

Fixed rate mortgages have their fans, who point to the peace of mind they provide first-time buyers on a tight budget who feel they might not be able to cope with higher loan repayments.

First-time buyers may also be steered into fixes if the lender gives them the higher mortgage approval they need to get on the property ladder, but only on condition that they accept a fix.

According to mortgage broker Liam Ferguson, IIB Homeloans does this on its three-year fix, while First Active will lend more money to people who take out its five-year fix.

But it is shorter-term fixes that are growing in popularity, he says.

"One- and two-year fixed rates are becoming increasingly popular, particularly so in the case of the lenders who will guarantee to let you get back onto their best tracker rate after you are finished the fixed rate."

These lenders are AIB, Ulster Bank and now Permanent TSB. But other lenders do not share this policy. For example, homeowners who took out Bank of Ireland's then competitive 3.39 per cent two-year fixed rate in November 2005 will not be allowed to revert to the bank's best tracker mortgage rates of 4.65-4.85 per cent when their fix expires later this year.

Instead the fixed-rate customer will see their mortgage "rolling" to a rate that is a margin of 1.25 percentage points above the ECB rate. At the current ECB rate of 3.75 per cent, this means they will be charged 5 per cent.

These policies make the financial squeeze suffered by people who come to the end of a good fix even more painful.

"Anyone who got a decent fixed rate last year was sheltered from the brunt of the interest rate increases, but they will then get hit by the full whack," says Conway.

Assuming there is just one further rate hike this year, homeowners who make the big jump from a rate of 3.39 per cent to 5.25 per cent will see their monthly repayments leap overnight from €1,107 to €1,381. Those homeowners will have to find that extra €274 a month or switch their loan to a new lender.

"We would certainly encourage people to review their mortgage, especially if they're coming to the end of the fixed term," says Connole.

Stung by last year's succession of interest rate hikes, homeowners are now more pessimistic than economists when it comes to the outlook for interest rates, according to the IIB Bank and Economic and Social Research Institute's recent consumer sentiment survey. A third expect interest rates to rise by more than one percentage point this year.

Even more pessimistic market observers expect only two more interest rate rises in 2007 from the ECB with a more popular view being that a June rate rise might be the last.

With regular letters from your lender passing on the bad news, fixed-rate mortgages seem tempting.

But homeowners looking for freedom as well as cheaper repayments will be better off keeping tabs on lenders' new tracker mortgage offers rather than searching for the magic fix.