Volatile rates make fixed loan decision very difficult

Many people are now looking at fixed interest rates, particularly over longer time periods. However, the problem with this is that it is impossible to predict what will happen to interest rates and you can end up paying over the odds.

Not only is it difficult to predict where interest rates will go on the money markets, it is also very difficult to know what impact competition will have on the rates on offer.

The markets are now predicting that rates are far more likely to rise over the next year or two than fall, and longer term rates have already begun moving up in the markets. However, there is also a chance that rates could come down again even further in the next cycle, as competition intensifies across Europe.

This could be as early as three to four years from now, or much later in the decade. It is likely to come from two sources. General transparency within the euro zone means there is a good possibility of a pfandbrife, a mortgage bond which is the main source of mortgage finance in Germany and elsewhere, arriving here. Before being introduced, these need legislative changes, but are likely within two to three years: they will allow finance at levels about 1 per cent over wholesale rates.

An even bigger development would be a move to the very competitive US system. This is based on a market where the redemption of fixed mortgages does not involve any penalty. This requires advanced skills from the lenders, as they have to write off the risks very carefully across the whole book, as well as a very liquid swaps market.

Nonetheless, it could well come to Europe over the next 10 years, as even the Germans feel competition intensifying in euro zone. This would be the end of penalties when getting out of fixed-rate mortgages.

At the moment, there is nothing particularly sophisticated available in the Irish market. However, there are options for those who are taking out very large mortgages who are worried that rates could have fallen again before their fixed rate expires. These are generally only used for investors taking out second and other loans, and usually only for amounts over £500,000. Apart from fixed rates, another option which is frequently used is a "cap". This allows you to set the top rate you are willing to pay at, but by keeping to a variable, will ensure you always have access to the lowest rate on the market.

For example, you could set your cap at 6 per cent and then the maximum you would have to pay over the period would be 6 per cent but you would pay the variable amount up to this level. At the moment, the cost for this is a once off premium paid on day one. A cap at 7 per cent may cost around 0.3 per cent or 0.4 per cent of your loan.

A slightly cheaper version would be to also take a "collar". This would allow you to set a lower limit which you say you would not benefit from. For example, you could set the collar at 4 per cent and thus any fall in rates below that would benefit the bank and not you. If you were to do this, you could take a small amount off the cost of the loan, say about 0.15 per cent. Another method is called a "cancellable swap". This would mean you would take out a cancellable swap for 7 per cent and by paying this extra margin you can decide to prepay your loan at any time without penalty: if rates were to fall again in a few years, you could get out of the loan and back on to a lower fixed rate. In general, the premium you would pay on this is around 1 per cent. So, if the 10-year fix is at 6 per cent, you would pay 7 per cent. It also usually involves having to keep the contract in place for, say, the first three years.

Another type of product which the bank could mention is a "zero cost collar". This sounds good but rarely works to the customer's advantage. This sets the cap and floor at levels where there is no premium to pay. The final product which the bank could mention to you is an "interest rate swap".

This is really only useful if you want to protect yourself from rising, rather than falling, interest rates. It allows you to swap a floating rate for a fixed rate; it also allows you to reverse the swap if you repay early.