Capped Rates – Mortgage Utopia or Mortgage Dodo?

The perfect mortgage?

At first glance, a capped rate seems like an unbeatable proposition. An interest rate type that has a limit on how high your interest rate could rise, but with the advantage of being based on variable rate for when interest rates fall.

As an example, a lender may offer a capped rate of 6.5%, with a starting variable rate of 6%. Traditionally, the variable rate is based upon a discount from the lenders Standard Variable Rate. Therefore, should rates fall and the lender reduces their Standard Variable Rate, mortgage repayments would reduce. But should interest rates rise, the lender can charge no more than 6.5% on the loan.

On paper, this would seem to suit both the risk adverse mortgage holder who does not want to gamble on payments becoming unaffordable, as well as the more adventurous mortgagor who wishes to take advantage of any potential falls in interest rates.

Why Few Lenders Offer Capped Rates

It would be useful to spend a few minutes searching Best Buy tables, internet search engines and mortgage magazines for an idea of current capped interest rates. You will quickly notice that very few lenders offer this type of mortgage. The key supporters of Capped Rates continue to be mainly building societies.

When lenders offer mortgage products to consumers, the pricing of the product is dictated, amongst other things, by their lending criteria and the credit risk of the applicants to whom they are lending. But clearly the lender must also factor in a profit margin. With a fixed rate, the cost is set at the start of the mortgage. With variable, the lender knows they can maintain a margin over the current prevailing rate. But with capped, the lender can do neither. This typically means that a capped rate is priced higher than either an equivalent fixed or variable rate to ensure the lender maintains a profit margin. The consumer is also paying a small premium for the extra facility and security offered by the product.

In recent years however, consumers have become more educated in financial planning due to the abundance of information now available in both the press, magazines, and of course the internet.

The majority of consumers now appreciate and understand the pro’s and con’s of fixed rate and variable rate mortgages, and prefer to make their own decision on whether they prefer the benefits of fixed rates (stable mortgage payments and/or the belief interest rates may rise) or variable rates (belief that interest rates may fall or obtaining a more flexible mortgage) and are therefore not prepared to pay the higher rates demanded by capped rate facilities.

A Future for Capped Rates?

Capped rates could have a future. Lenders need to think carefully about their pricing structures for this type of product. Consumers are shown to prefer tracker rate deals to lenders variable rate deals as this ensures their own mortgage rate follows Bank of England movements, so that would be a good starting point for any lender.

And the product should be priced at a point where consumers believe they are receiving value for money on their mortgage. This is certainly the hardest part for the lender, and only time will tell whether Capped rates have a future in the modern mortgage market, or whether this type of mortgage scheme finally goes the way of the dodo.

Note:

A slight variation of the capped rate mortgage is called ‘cap and collar’. Quite simply, the cap is the highest rate the mortgage holder would pay, and the collar is the lowest. This type of scheme is virtually non-existent in the current mortgage market.

Article by: Chris Baigent 13-11-2007

The articles on this site solely reflect the personal views of the authors and do not necessarily represent the views, positions, strategies or opinions of Smaart Associates Limited. All comments and opinions are made in good faith, and neither Smaart Associates Limited nor the author will accept liability for them.