The Bank of England Governor, Mark Carney, has talked of a 2.5 per cent base interest rate as the "new normal". What, if anything, should you do? By Hamish McRae
Interest rates are going to rise. We know that with as near 100 per cent certainty as there can ever be in financial markets. But what will it mean for you? Long-term rates have already have started to move, with ten-year gilts now yielding 2.6 per cent, against a low of 1.5 per cent two years ago, and Goldman Sachs expects them to rise to 3.4 percent in a year’s time.
What we don’t know is when the Bank of England’s monetary policy committee will vote for the first increase in Bank rate, currently 0.5 per cent. However, the markets expect the first increase of 0.25 per cent to come either in November this year or February next, and then to come at three-month intervals thereafter.
So, not knowing exactly when interest rates will rise, what do you do? Should you try to become your own personal interest rate calculator?
Well, there is nothing you can do to outwit the markets. If, for example, you want to try to bolt down a fixed rate for your mortgage, you will find that the expectation of higher rates had already pushed up what you will have to pay. You can shop around but you should do that anyway.
So the sensible way to prepare for higher rates is to use this as a nudge to spring clean both your borrowings and your savings, the two sides of the household balance sheet.
On the borrowing side, going for a fixed mortgage is insurance. The new Bank of England guidance for banks and building societies is that they should stress-test the finances of would-be borrowers to see if they could afford to service their mortgage if rates went up by three percentage points. That is rather sensible; so sensible in fact that everyone ought to do it.
A fixed rate costs more than a floating rate but it gives certainty and it is quite likely that Bank rate in three years’ time will indeed be 3.5 per cent, and could be more (see below).
The other obvious thing to do is weed out any high-cost borrowing – credit cards that are not paid in full at the end of the month, unauthorised overdrafts and the like – and replace them with lower-cost debt. A second mortgage is more expensive than a first mortgage but cheaper than a credit card. It may sound harsh but banks make their money from sloppy customers.
On the savings side, the same principle applies: do a spring clean. The obvious thing to do would seem to be to stay liquid and wait to take advantage of higher rates – and that would be quite wrong.
Higher rates are already available, if you hunt for them, but there is usually a catch. Typical catches include requiring depositors to have the salary cheque paid into it, or direct debits paid out.
So beware higher headline rates. Instead think about a longer-term strategy for savings, in which any sensible plan must include some equity element. No one knows what the stock market will do next but a high-yield equity fund should, over the years, bring a much better return than a bank deposit.
Remember this. What is notionally deemed by the authorities to be high risk, such as equities, are on a long view not that high a risk. And investments that are deemed to be low risk, such as gilts, are actually bound to lose capital value in an era of increasing interest rates.
But might higher interest rates be bad for the economy and hence depress share prices? That is a familiar argument and there is some merit in it. But if you ask why rates are going up, it will not be more in response to a rapidly-growing economy than to fears about inflation. Rates will rise because the economy needs higher rates, not to damage the recovery.
The big point here is that we are getting back to normal. So the rules that applied post the banking crash of borrowing if you can get the money and having to scramble around to get some sort of return on your savings will cease to apply.
The new normal won’t be quite the same as the old normal for it is likely that interest rates in general will remain quite low for some time. Mark Carney, the governor of the Bank of England, has suggested that the “new normal” for interest rates is likely to be about 2.5 per cent. It could, of course, be higher.
But the old rules will apply again and the transition to the new normality is a great time to do the basics of financial management. It is not so much a question of protecting oneself against higher interest rates or seeking to take advantage of them. It is more a matter of being orderly and sensible, and using the now upward movement of interest rates to prod oneself into action.