A few weeks ago, before the war in the Gulf and the closure of the Strait of Hormuz, investors were debating how many times the Bank of England would cut interest rates by the end of the year. Now they are debating how many times it will raise them.
One immediate impact of that dramatic swing in interest-rate expectations has been a change in the mortgages banks offer. In mid-February, two- and five-year fixed-rate mortgages were available at below 5%. Now they are both more like 5.8%, a notable rise for anyone about to remortgage or to take out a loan. And plenty of Britons will soon find themselves in that position. UK Finance, an industry trade body, reckons 1.8 million fixed-rate mortgage deals will expire over the course of 2026 – the vast majority of them either five-year deals taken out when rates were super-low in 2021, or two-year terms dating back to 2024.
A few weeks ago, UK Finance estimated that those facing an expiring two-year deal could expect to see their monthly repayments rise by around £37. But people coming off a five-year fix would be exposed to an average monthly rise of £395. And when you have to pay more, where does that extra money actually go?
It is worth stepping back and remembering that the Bank of England, and its Monetary Policy Committee, do not directly set mortgage rates. Instead, they set the “bank rate”, the rate at which the central bank itself pays interest on money deposited with it by commercial banks and building societies, and the rate it charges those institutions to borrow. This is, essentially, the anchor interest rate for the economy as a whole. And as the bank rate rises or falls, commercial banks and building societies adjust their own interest rates.
Fixed-term mortgages are priced to reflect market expectations of what the bank rate will average over the term of the deal. If markets expect the Bank to cut interest rates in the coming year, then a two-year mortgage will probably be cheaper than a tracker mortgage, which reflects the current bank rate. Likewise, if the Bank of England is expected to be increasing borrowing costs, then a two-year mortgage rate will be – as at present – higher than a tracker.
So, when a mortgage holder sees their monthly payments rise, that mostly reflects their lender itself facing a higher cost of funding. The word “mostly” is doing a lot of work here. If someone’s mortgage repayments go up by £100 a month, that does not necessarily mean that their lender’s cost of funding has also risen by exactly £100 a month.
Generally, increases in interest rates feed through much faster into the cost of loans than the return on deposits. When interest rates are going up, bank profit margins tend to, in the short term at least, rise a bit. Those margins usually slip in a falling-rate environment.
At the level of the whole economy, a rise in interest rates acts as a form of redistribution, transferring money and spending power away from borrowers and towards savers.
In general that means that working-age and poorer households (more likely to be debtors) lose out. Older, wealthier households – those more likely to hold savings – do better. This may sound unfair, but it is worth keeping in mind that the opposite is true when rates are being cut.
And this is very much a feature of how monetary policy works, not a bug. By increasing interest rates, the Bank of England hopes to transfer spending away from those most likely to actually spend and towards those more likely to save it. Reducing the amount of spending in the economy lowers demand and, hopefully, reduces pressures for prices to rise, helping to bring the rate of inflation down.
When someone’s mortgage payments rise by, say, £200 a month, their lender is not simply pocketing that money. The vast bulk of it will flow, ultimately, to some saver or another who is less likely to actually spend it.
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The reduced spending power of the mortgage, together with the cancelled or postponed investment and hiring plans of firms no longer able to borrow as cheaply, is all part and parcel of the painful process by which higher interest rates are supposed to slow an economy and keep inflation in check.
To recap then, the closure of the Strait of Hormuz puts upwards pressure on inflation by increasing energy prices. In the view of investors, that means that the bank rate is more likely to rise than fall in the coming year.
Even though the Bank of England itself has yet to do anything, the very fact that expectations have changed has already led to a large shift in mortgage pricing. The redistribution from borrowers to savers has already begun.
Duncan Weldon is a journalist, and former political adviser, researcher, and market strategist
