Tracker or variable - which mortgage should I pay down first?

I have two mortgages – the larger on a tracker at 1.1 per cent over the European Central Bank and the smaller from a later renovation now on 3.25 per cent, so cheaper than the tracker.

I have come into some money and always planned to pay off the smaller variable mortgage when this happened – but now it is actually cheaper than the tracker.

I have been waiting to see what happens but doing nothing is costing me money.

Which one should I put the extra funds towards? Surely the variable will become more expensive but hasn’t yet.

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I have 13-14 years left on them and I am, as of recently, with Bank of Ireland.

Many thanks,

Ms AC

Welcome to the world of soothsaying. You are asking me to peer into the future on the behaviour of banks that are not currently responding in a way you would expect them to.

Logic says that as interest rates rise, banks will increase the rates at which they offer credit to customers. But that hasn’t been happening.

Since the European Central Bank starting raising its interest rates from zero last July, Ireland’s banks have shown themselves to be very reluctant to increase interest rates.

Tracker mortgages have risen, of course, as they move in line with ECB rates. And though many mortgage holders whose budgets had adapted to the near decade-long era of cheap credit are feeling the squeeze, the terms and conditions of these loans are clear and people at least cannot say they did not know what was coming. If they maxed out their budgets in line with historic low rates, they will clearly have to adjust priorities.

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Fixed rates have also increased, though not by anything like the rise in ECB rates. You are now with Bank of Ireland, presumably following the departure of KBC from the Irish market. Even including the increase in fixed rates on mortgage loans that came into force last week, rates at that bank have risen by less than half the total jump in the ECB rate.

And then there are variable loans. These are generally the most volatile end of the market but, in common with most lenders, Bank of Ireland has been remarkably reluctant to raise their variable mortgage rates. To the best of my knowledge, the Bank of Ireland variable rate is still the same as it was back in July last year, unless I have missed an announcement.

It’s all very puzzling. The reason the ECB is raising interest rates is to damp down inflation. By this logic, Irish banks are actively working against the stated policy of both the ECB and the Government.

On the other hand – as the banks themselves would certainly present it – Irish consumers are already contending with significant increases in the cost of living over the past year. Much of this obviously has stemmed from energy prices and the knock-on effect of that as it feeds through the food chain.

And there is a certain logic here as one thing the banks are keen to avoid is another credit crisis with mushrooming non-performing loans. They are only just now getting out from under the weight of soured credit that was triggered by the last financial crisis 15 years ago. Addressing non-performing loans is an expensive issue for lenders.

And, of course, they can afford to keep discretionary rates at levels below what might be expected. One of the consequences of the ECB return to a policy of raising rates is that the institution is now paying Irish (and other) banks interest on money deposited with the Frankfurt institution. This is a big turnaround from the situation last summer when banks were having to pay the ECB to look after their excess deposits.

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The ECB introduced negative interest rates on deposits back in 2014 and that rate had risen to -0.5 per cent in the three years in advance of last summer. Now banks are getting an annualised positive interest rate of 3 per cent from the ECB – so a similar 3.5 point swing as we have seen on the headline rate. That turnaround in fortunes means that the banks have less need to tap their customers with higher rates to maintain their profit margins.

Quite how altruistic you can expect banks to be is an open question. In a paper published last week, the ECB made clear its view that companies padding out their profits have been a noticeable contributor to stubbornly high inflation rates. That referred to companies in the wider economy, not banks, but it is still asking a lot to expect banks long term to deliberately shun the prospect of profit in a rising interest rate environment.

So back to your two loans. Until recently, the assumption was that rates would continue to rise and remain higher over the next several years as the ECB, the Fed and others look to lock inflation in around the 2 per cent level.

That strengthened the argument for you to use any windfall cash to pay down the tracker rate, especially as you are paying a margin of 1.1 percentage points above ECB, so a rate of 4.6 per cent currently versus 3.25 per cent on your variable rates.

However, recent events have served only to further muddy the waters.

The new higher interest rate environment caught out several smaller US banks, including one called Silicon Valley Bank that had unwisely effectively placed all its bets on an ongoing low interest rate environment. Changed circumstances led to a run on the bank and that has proved a catalyst.

[ Euro zone inflation drops as energy costs ease but interest rate hikes still on the cards ]

As increasingly nervous markets hunted for signs of weakness, Swiss banking giant Credit Suisse was forced into a marriage of convenience with its biggest rival, UBS, as time to get itself back in shape ran out after a decade of poor management and scandal. Deutsche Bank, too, saw its shares hit.

The prospect of another banking crisis has given central banks pause for thought and they are now having to juggle the competing challenges of raising rates to subdue inflation and the potentially negative impact of such rate rises on lenders.

The outcome is likely to be rates rising more slowly to a lower cycle peak than previously predicted. There is even talk for the first time since central banks started raising rates as to when they might start bringing them lower again.

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So your tracker may not become as expensive as previously expected and the tracker rate may even start coming down sooner than we thought – although it’s not getting anywhere back near the historic lows it stood at in advance of last summer.

At the same time, with interest rates not likely to rise as far or as fast as they had previously thought, banks may start looking at those variable rates as a way of making up for any shortfall in anticipated profit levels.

A three-quarter point rise in variable rates and a similar fall in ECB rates would suddenly see the cost of your respective loans change.

There are a lot of ifs, buts and maybes in this answer and the truth is, unsurprisingly, that I have no greater insight into what will happen over the next year that anyone else. Circumstances can change the picture rapidly as the simmering bank crisis has shown.

I do expect variable rates to rise eventually but by how much I have no idea. Similarly, tracker rates will peak and even come back a little from that peak but precisely when and by how much I could not say with any certainty.

Please send your queries to Dominic Coyle, Q&A, The Irish Times, 24-28 Tara Street Dublin 2, or by email to dominic.coyle@irishtimes.com. This column is a reader service and is not intended to replace professional advice