How lenders set their mortgage rates

Learn more about how lenders price their mortgages and what happens with the Bank of England base rate changes.

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By

Kate Steere

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You probably know that the Bank of England base rate impacts mortgage rates, but what could it mean for the amount you pay for your mortgage? This guide explains how mortgage interest works in different mortgages, how mortgages are priced and what it means for you if the base rate changes – whether you have a mortgage or are planning to get one.

What are mortgage rates?

A mortgage rate is the interest rate you’ll be offered as part of your mortgage deal. As you’re borrowing money from your lender, you’ll pay interest on the loan.

The mortgage rate your lender offers you will depend on factors such as how risky the lender thinks you are, what type of mortgage you take out and the Bank of England base rate.

How does interest work in different mortgages?

There are different types of mortgages and the interest works differently as a result. Here are some of the most common mortgage products available.

Standard variable (SVR)

The rate on this mortgage can change during your policy. Each lender will set their own standard variable rate. While it is not directly linked to the base rate, it is heavily influenced by it.

What happens if the base rate changes?

For those on a standard variable rate mortgage (SVR), you could see an immediate change in your monthly payments – depending on what your lender decides to do.

If the base rate were to rise by 0.5 percentage points, your lender can increase its SVR by 0.5 percentage points or more. It can also increase its SVR by less than 0.5 percentage points or do nothing, but that’s unlikely to happen.

Tracker

This type of mortgage rate is directly linked to the base rate. The interest you pay on your mortgage is likely to be the base rate plus a percentage.

What happens if the base rate changes?

As soon as there is a rise or fall in the base rate, the interest rate on your mortgage will change.

For example, your tracker mortgage is the base rate (currently 5.25%) plus 1%. If the base rate were to increase by 0.5 percentage points, the rate on your tracker mortgage will also increase by 0.5 percentage points.

Fixed rate mortgage

As it says on the tin, a fixed rate mortgage has an interest rate that is fixed for a set period of time. There are different term lengths, typically from 1–5 years.

What happens if the base rate changes?

For existing fixed rate mortgage customers, your payments will remain unchanged as your rate is fixed.

New buyers or remortgagers may see a change in mortgage rates, but these are unlikely to be immediate unless the swap rate has also changed (more on this below). Similarly, if there is volatility in the swap rate market, some mortgage products could be pulled.

How do lenders set fixed rate mortgage rates?

The price of a fixed rate mortgage is determined by lots of factors. While the pricing for a variable rate mortgage relies on the base rate, lenders have to consider more factors to set the price of fixed rate mortgages.

Here are all the factors lenders use to set their fixed mortgage rates:

Base rate

This is the factor that dominates the headlines, especially when there’s a change. However, the Bank of England base rate – or bank rate – doesn’t have as direct an impact on fixed rate mortgage pricing as some of us may think.

The base rate determines the interest rate the Bank of England pays to banks that hold money with it. Therefore it impacts how expensive it is to borrow money. As a result, rates often rise and fall in line with the base rate.

Retail savings

Banks need funding in order to lend. One of the major ways they get funding is through “retail deposits” (money you put in your bank account) from consumers and small companies. The level of retail savings a bank has will determine how much it can lend and at what price.

Wholesale funds

Wholesale funding is used if a bank wants to borrow more than what it has in retail deposits. It can borrow from other banks or financial institutions, or it can use its assets as collateral and borrow funds from investors.

Swap rates

The swap rate is the secret factor that actually drives the pricing. Swap rates are what lenders pay to financial institutions to get fixed funding for a set period. It’s based on what the markets think interest rates will be over the term of the swap rate.

If there’s a rise in swap rates, lenders will increase their pricing to maintain their profit margin. If they rise too rapidly, lenders tend to pull products and wait until swap rates have stabilised.

Typically, it’s also why any increase in the base rate won’t have an immediate effect on fixed mortgage rates. This is because swap rates are based on assumptions of what interest rates will be, so the base rate rise or fall will have already been priced into the mortgage rates.

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