Mortgage interest rates close to their floor - Capital Economics
UK Housing

Mortgage interest rates close to their floor

UK Housing Market Update
Written by Gabriella Dickens

Increased competition among lenders has caused mortgage interest rates to fall in recent months. But funding costs are set to remain pretty stable. That, combined with already tight interest margins and increased regulation, leaves limited scope for rates to fall much further.

  • Increased competition among lenders has caused mortgage interest rates to fall in recent months. But funding costs are set to remain pretty stable. That, combined with already tight interest margins and increased regulation, leaves limited scope for rates to fall much further.
  • Lenders have been embroiled in a mortgage price war. The average quoted rate on a new 75% LTV five-year fixed rate mortgage edged down to just 1.96% in July, a two-year low. And more recently, Santander announced a five-year fix at just 1.55% and HSBC, a five-year fix at 1.59%.
  • Several factors have caused lenders to lower their mortgage interest rates. First, lenders’ funding costs have edged down. Our estimate of funding costs has fallen by around 10bps since the start of the year, reaching 0.91% in August. (See Chart 1.) Moreover, banks have cut their mortgage rates to compete for market share. Such behaviour can be seen in lending spreads – the average gap between the price of a 95% and 75% LTV loan has narrowed by around 75bps since July 2018.
  • Looking ahead, funding costs should stay pretty stable over the next 12 months. If a no deal Brexit is avoided, Bank Rate is set to increase to no more than 1% by the end of 2020.
  • Admittedly, in a no deal Brexit scenario wholesale funding costs could spike. But the rate on a five-year CDS only rose by around 40bps in 2016, around the Brexit referendum. In a no deal Brexit, we expect Bank Rate to be cut to at least 0.25%. So any rise in the risk premium on bank funding would probably be offset by a lower risk-free rate. And in any case, banks have been far more reliant on deposit funding since the financial crisis, further limiting the impact of any wholesale funding shock. (See our Update, “Is the fall in interest margins overstated?” 11th June 2019)
  • Furthermore, despite relatively low funding costs, lenders’ margins are still pretty narrow. We estimate that interest margins are currently at around 1.15%, just above July’s ten-year low of 1.08%. Granted, margins are still some way above those seen prior to the financial crisis, which were around 50bps lower on average. (See Chart 2.) But capital requirements are more stringent now, so we doubt they will fall that far. At best, there is a little wiggle room left, with the floor on margins probably somewhere around 1%.
  • All in all, with interest margins able to be squeezed slightly more, mortgage rates could still fall by around 10bps. But the big picture is that mortgage interest rates are now very close to their floor. And with banks still largely upholding their credit standards, we doubt the mortgage price war will translate into an imminent recovery in mortgage lending volumes anytime soon.

Chart 1: Bank Rate & Lenders’ Funding Costs (%)

Chart 2: Lender’s Interest Margin (%)

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics


Gabriella Dickens, Assistant Economist, 020 3974 7421, gabriella.dickens@capitaleconomics.com