BoE raises interest rates to 2.25%: what this means for mortgages, debt and savings

Alice Haine, Personal Finance Analyst at Bestinvest, the DIY investing and coaching service, says the 0.50% hike in the benchmark lending rate marks the seventh increase in a row and takes the base rate to the highest level since December 2008.

“The Bank of England’s decision to raise the benchmark lending rate by 50 basis points at this month’s meeting, delayed a week by the mourning period for Queen Elizabeth II, marks the first-time interest rates have risen by 0.5% over two consecutive months since December 1994.

“The Monetary Policy Committee’s 5-4 vote in favour of the 0.50% hike sends a strong signal that the Bank is serious about getting inflation back down to more palatable levels in the medium term, with three members voting for a more aggressive 0.75% hike, as it looks to curb the worst bout of inflation in 40 years and edge closer to its target of 2%.

“Prime Minister Liz Truss’ energy plan has taken some of the heat off the Bank as the fiscal move to freeze utility bills at £2,500 for two years for the typical household and extra help for businesses could reduce the inflation peak by several percentage points leading to a milder than expected recession. But it has not solved all the central bank’s woes.

“Inflation may have come in lower than expected in the 12 months to August at 9.9%, down from 10.1% in July, but it is still alarmingly high as the cost-of-living crisis fuelled by global challenges, namely Putin’s war with Ukraine, rumbles on.

"As a result, the BoE still expects inflation to peak at just under 11% in October despite Truss’ energy plan, as the resulting boost to economic activity from the two-year freeze on energy bills and Chancellor Kwasi Kwarteng’s swathe of tax cuts set to be unveiled in the mini-budget on Friday could see inflation stay higher for longer.

“With even stagnant GDP growth at the start of the summer and plummeting retail sales in August failing keep a lid on rising prices, something not helped by the robust labour market with unemployment at its lowest rate since 1974, household finances are still under strain.

“With some households already struggling to absorb the reality of paying almost 10 per cent more for a basket of goods than a year ago – the prospect of even higher mortgage rates could be a real tipping point for some.

“The Government’s package of handouts and emergency measures to support struggling households may receive more impetus when Kwarteng delivers his mini-budget on Friday as the Chancellor pins his hopes on growth, but that doesn’t mean household finances aren’t already stretched to the max with some people forced to budget very carefully just to keep their heads above water.”

Mortgages

“A 50 basis point increase in the base rate is never good news for borrowers – but in these already constrained times, it delivers another hefty blow to the finances of mortgage holders and those with debts to contend with.

“Naturally nobody wants to pay more to clear their mortgage, loans or credit cards, but the BoE feels it must act aggressively to prevent inflation staying high for longer, in turn drawing out the squeeze on living standards for longer.

“When it comes to mortgages, another chunky base rate rise is particularly bad news for first-time buyers as it dampens their affordability levels at a time when house prices are still on the rise.

“Homeowners on tracker mortgages or those whose fixed-rate deal about to expire will also face more pain because banks and building societies are more than likely to hike their mortgage rates again.

“It’s not all bad news, however. Most UK mortgages are fixed – in fact three-quarters of them are with most new borrowers choosing the fixed-rate route since 2019*. This means anyone in the early stages of a five or 10-year mortgage can relax for now, particularly if they locked in a good deal before interest rates started their upward trend in December last year.

“Homeowners with fixed rates expiring imminently or in the next few months will be feeling less relaxed as the prospect of a higher mortgage repayment piles further pressure on household budgets already constrained by startling rises in the price of food, energy and fuel over the past year.

“The shock will be felt most acutely by those who locked themselves into mortgage deals during the era of ultra-low rates – as they are now emerging into a very different landscape where the average two-year fix comes in at well over 4%.

“If they haven’t taken action in the run-up to their existing deal’s expiry date, then they need to act very quickly otherwise they risk ending up on their lender’s standard variable rate – one of the most expensive forms of mortgage borrowing.

“However, with more rate rises to come this year and next, getting sound advice in this fast-moving mortgage landscape, where some deals only stay live for a matter of days, would be a good idea. Finding the right product to suit future plans is key as locking into a longer term, such as a five,10 or even 15-year fixed rate might not be wise for those that might want to clear a mortgage early or secure lower rates further down the line.

“With average rates on two-year fixes now almost double what they were a year ago and many lenders pulling products from the market amid surging demand, acting fast and getting your documents in order will be crucial to ensure you get the deal you want.

“Remember, some lenders allow you to lock in a fixed rate up to six months before a current deal comes to an end – something that allows borrowers to get ahead of future rate rises – so start looking for a new deal now if your current deal is expiring next spring.

“Anyone still on a tracker mortgage, where the home loan tracks the BoE base rate, will see this latest base rate increase automatically applied, so, again switching to a fixed-rate offer is the most sensible move here – with the same strategy applying to borrowers on a lender’s standard variable rate.

“With more interest rate rises expected those with any spare funds should overpay now to reduce the hit when the renewal date comes around. Fixed-rate mortgages generally have an annual overpayment limit of 10% of the total outstanding mortgage balance. However, anyone with a tracker mortgage or the lender’s SVR, generally has no limit, so if you have the cash then pay off what you can, particularly as it could also help to secure a better deal further down the line if you move down a loan-to-value band – say from 65% to 60% - in the process.”

Debt

“It’s not just mortgages that are negatively affected by rising interest rates. Those with debts to contend with also face more expensive loans, credit cards and overdrafts if banks pass on the increased rate, a concerning factor when it is likely more households will use credit to pay everyday expenses during the crunch on living standards.

“Consumers borrowed an additional £1.4bn in credit in July, a further jump on the increase of £1,8bn in June – with half of that sum on credit cards alone - highlighting just how difficult the current environment has become.

“Anyone with an existing fixed-rate personal loan or car loan does not need to panic yet as the terms of their loan have already been agreed, but new borrowers shopping around for credit may find the cost of debt higher.

“Anyone with a small credit card balance they are struggling to clear should consider switching to a 0% balance transfer deal to buy themselves some breathing space. This gives them an interest-free period to pay back the debt at their own pace without the fear of the debt compounding out of control.

“For more substantial debts, such as a large overdraft or multiple maxed-out credit cards, consolidating them into a personal loan with one fixed repayment a month will ease the financial stress that can come with heavy liabilities.

“Personal loan rates have been on the rise in recent weeks but they are still relatively low and while the ultimate strategy in this ongoing cost-of-living crisis is to trim your expenditure where you can rather than take on additional debt. If there is no other option, then look to borrow as little as possible over the shortest time possible at the lowest rate you can find.”

“An interest rate rise is always on the surface a welcome bit of news for savers, particularly as this new era of base rate hikes follows more than a decade of ultra-low borrowing costs. However, with the BoE expecting inflation to peak at just under 11% in October and remain above 10% over the next few months, the real return on any cash sitting in a savings account will be deeply negative – no matter how great the headline rate is.

“Actually being able to save at all will be the biggest challenge for many in this cost-of-living squeeze as they contend with higher food, energy and mortgage costs, but those lucky enough to have money to set aside each month must shop around for the best rate to make their money work as hard as it possibly can.

“With the best easy-access accounts climbing to 1.95% this week and the best fixed-term accounts hitting 3.82%, every penny in additional interest will be crucial in the fight against high inflation, which eats away at our spending power. But it might be worth waiting a little while to let the latest interest rate rises trickle through from lenders to savers.

“While banks and building societies are quick to apply higher rates to debt, they can be a little slower to deliver the good news to savers. So, hold off for the best deals if you can.

“While having an emergency fund of at least three to six months is the ideal to cover any unexpected events such as job loss or a faulty car, households with no backup funds set aside should not be too hard on themselves. These are tough times and rectifying the situation simply requires you to start saving today. A small sum set aside each month can quickly grow into a safety net that offers some security in these uncertain times.

“Those with longer-term savings goals – more than five years and ideally at least 10 – should consider investing their money in the markets. While higher returns from the markets can never be guaranteed, a long-term approach allows a diversified investment portfolio to absorb the highs as well as the lows and deliver better growth and potentially inflation-beating returns over the long term.”

* According to UK Finance