It protects residential, buy to let (BTL) or commercial mortgages from rising rates.
It allows a borrower to choose the level at which to apply a cap and also for how long they wish to buy the protection.
Borrowers with mortgages of at least £500,000 buy a cap of their choice; caps are available for periods from 3 years upwards as John Charcol doesn’t believe shorter-rate caps to be cost effective.
The cap will allow the borrower to continue benefiting from their low rate as long as rates remain low, but provide an insurance policy against rates rising above a level at which they may find the payments uncomfortable, particularly if Bank Rate rises quicker than is currently expected.
Just as when buying buildings and contents insurance one hopes not to have to claim on the policy, but can sleep soundly at night in the knowledge that the insurance will pay out in the event of a burglary, the cap does exactly the same for mortgage payments.
The cost of buying the cap, which must be paid in full when purchased, varies daily with market conditions. The minimum cover which can be purchased is £500,000 and the unit cost falls as the loan size increases.
For example, a five year cap to cover a £500,000 mortgage currently costs approximately £16,500 for a cap at a 3% Bank Rate, £13,500 for a cap at 4% and £11,500 for a cap at 5%. Cover for a £1m mortgage would be approximately £28,000, £22,000 and £18,000 respectively.
If Bank Rate rises above the chosen level, monthly payments to cover the difference between that level and Bank Rate will be made either until the end of the insured term or until Bank Rate falls back below the chosen level.
Anyone considering buying a cap needs to take account of the margin above Bank Rate or Libor they are paying on their mortgage when deciding at what level to buy the cap.
For example if their mortgage is at Bank Rate + 0.5% and they buy a cap with a reference price for Bank Rate at 3% the cap will start paying out when their mortgage pay rate is 3.5%, i.e. the 3% Bank Rate + the 0.5% margin above Bank Rate for their specific mortgage.
Buying a cap may have tax implications, which will vary depending on the tax status of the purchaser(s), and so all purchasers should seek specialist tax advice.
It is particularly suitable for those borrowers already on a cheap variable rate, such as tracking UK Bank Rate, 3 month Libor in sterling or any other major currency, or a low Standard Variable Rate (SVR).
According to John Charcol it will often work out considerably cheaper than the traditional market alternative, a fixed rate, and provides a timely solution for many borrowers who, for various reasons, cannot, or do not want to, switch to a fixed rate.
Commenting, John Charcol’s Ray Boulger said: “Unless you are the proud owner of a crystal ball, knowing what the future for interest rates looks like is all but impossible.
“What we do know however is that we are in challenging times with plenty of known unknowns. With many borrowers currently enjoying the benefits of an ultra low interest rate environment, those on a variable rate risk some tough times ahead when rates, as they simply have to at some stage, rise.
“History and common sense suggests locking into a fixed rate is the way to protect against a rise in interest rates, but The Interest Rate Protector provides a different and often cheaper way to buy protection.”
Some scenarios where the Interest Rate Protector would be a viable option:
• If you are currently paying a low lifetime tracker rate or a cheap SVR linked to Bank Rate, i.e. the 2.5% rate of Nationwide, Cheltenham & Gloucester, Lloyds TSB and Intelligent Finance.
• If you are unable to remortgage to a good fixed rate because of a lack of equity.
• BTL landlords who are unable to protect their payments due to high gearing and/or an inadequate rental income to meet lenders’ current criteria.
Boulger continued: “Two key considerations when considering whether to remortgage must be the current rate a borrower is paying and the loan to value (LTV) needed for a new mortgage.
“It goes without saying that the lower the rate currently being paid the less likely a borrower will want to switch to a more expensive fixed rate.
“Likewise the higher the LTV needed the more expensive the new fixed rate will be, whereas the cap pricing is completely unaffected by the LTV.
“For borrowers who are currently paying a low rate on a lifetime tracker or SVR there is another equally important factor to consider. If they want to move back to a variable rate when any new fixed rate finishes they will not only revert to a rate that is probably much higher, it is highly likely that they will also never again be able to obtain a rate with such a low margin over Bank Rate.
“Thus many borrowers face a challenging judgement call if they decide they want some protection. Those paying under 1% now, for example, would see their rate more than quadruple if they moved to a five or 10 year fixed rate and no-one is really likely to be prepared to swallow that.
“And, in the current economic environment, switching to a fixed rate for a shorter period would, in most cases, be pointless.
“It is impossible in advance to calculate the savings which may be made by buying a cap instead of switching to a fixed rate.
“This is because it will depend on how far and how quickly Bank Rate rises, although other relevant factors such as the cost of the cap and the price of a fixed rate mortgage will of course be known.
“The upfront cost of buying the cap will be an issue for some borrowers but providing they can find the relevant amount what they should consider is the maximum total cost over the timeframe they are looking at.
“To put this in perspective anyone who took out an interest only tracker mortgage 2 years ago when Bank Rate was at 5% would have made a sufficient saving on the cost of their mortgage over the last 9 months to pay the total cost of a Bank Rate cap at 3% for 5 years.
“On the same basis it would have taken just over 6 months of the lower mortgage payments to cover the cost of a cap at 5%.”
