If you have ever wondered how mortgage funding works, or more importantly, understand how you can take advantage of it, please read on
How Mortgage Rates Work
It would appear that Brexit is now the DFS sale of politics, and will simply go on, and on, and on… forever…
So as we adjust to this new norm, I have taken a step back to look at some basic market fundamentals to see where we are and what we can learn.
In essence, funding for a mortgage is actually very simple (or I would not be able to understand it…). There are 3 key factors to consider – LIBOR, 2 Year SWAP rates and 5 Year SWAP Rates and the relationship between them. By understanding how the relate to one another, you can start to see how funders view the market which therefore helps shape a clearer picture of the future.
How these work are as follows:
LIBOR stands for London Inter Bank Offer Rate (as most money cleared worldwide goes through London. That is a longer story to explain why, but basically it’s because London rules the world :-). LIBOR is a true reflection of the rates at which Banks lend to one another and typically funds Tracker Mortgages. LIBOR tries to guess when the Bank of England will move their Base Rate. I was taught all the way back in 2003 (when I became a broker), that when 3 Month Sterling LIBOR reaches 0.25% above or below the current Bank of England base rate (currently at 0.75%) expect a rate move in that direction, in the next 3 months, as the Bank of England typically moves the Base Rate in 0.25% chunks. I track this closes as it hugely impacts on the advice we give. As of Friday LIBOR was at 0.844%, which tells me there is about a 37% chance of a rate rise in the next 3 months (the % difference between 0.75% and 1% and where LIBOR currently sits). That hints that the Bank of England will most likely move rates up next, but just not in the next 3 months (as the tipping point is being more than 50% of the difference, so in this case, LIBOR being above 0.875% for a period of time). Huge word of caution here is that this is the “market expectation” and is by no means a guarantee. We have seen quite large increases in LIBOR the last few years but yet the Bank of England haven’t moved rates. This is very much an art, not a science as so many factors play a role in when the Bank of England move rates, like Inflation and Wages etc. LIBOR also reflects the availability of money as well as cost. That does start to get more complex at this point but I may pick up that topic another day.
2 & 5 Year SWAPs work exactly the same way. These are the money market rates guessing where rates will be over the next 2 or 5 years which has a huge impact on the price of Fixed Rate mortgages. As of Friday, 2 year money was at 1.087%, which tells me banks are only expecting one rate rise in the next 2 years. 5 year money was at 1.258%, which tells me banks are only expecting 2 rate rises. That paints a very negative view of the economy which I don’t agree with. I personally think rates will go up faster in the next 3, 4 or 5 years, which means the economy will also be growing. Again, the standard word of caution here that no-one knows where rates will ultimately go, it is all educated guess work. However, I believe that people are disproportionally influenced by recent events. So the doom and gloom surrounding Brexit has impacted here I feel. So in my humble opinion, that makes 5 year deals look great value.
I have added a graph below so you can see the interplay of these aspects:
Banks will then apply whatever margin they feel appropriate to the above market rates. That will then take into consideration your personal situation like credit profile, income, deposit etc. Hence why speaking to an adviser is so crucial. The above is all well and good, but if you have a specific need, your own view on rates or set situation, it then a case of finding the most suitable product, not just ‘cheapest’. That is why advice always plays a role as it is not a ‘one size fits all’ policy.