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Swap rates: What they are and how they work

Even if you're on a long-term fixed rate mortgage, you're probably keeping an eye on interest rates and how they may change once the UK leaves the European Union.

After all, a change in interest rates will affect your borrowing at some point, whether it's now or in the future.

So, with that in mind, it pays to be aware of what's happening at the Bank of England (BOE) - particularly for landlords, whose income may be reduced by a rate rise.

If your mortgage is on a variable rate, you'll probably be keeping an even keener on eye how things pan out between London and Brussels and whether or not that affects BOE interest rates.

One way to ensure you're on top of everything when it comes to your own mortgage and what you pay out is to be aware of swap rates.

In this piece, we'll take a look at what swap rates are, how they work and how you can use them to your advantage when it comes to your own mortgage.

What are swap rates?

If you Google 'swap rates', we'd forgive you if you were put off even clicking any of the explanations.

Because it's fair to say swap rates do appear complicated at first glance.

Essentially, though, a swap rate is exactly as it sounds and is when two different parties swap interest rates.

And it comes down to those fixed and variable rates once again, so in a swap, one party is keen to receive a fixed rate payment and the other a variable rate payment.

Of course, only one party can win and interest rate swaps are almost like betting on the horses - you study the form and then place your bet.

If one party believes interest rates will rise in the future, they may want to swap on to fixed rate of payment.

Alternatively, a party that believes interest rates will fall would want to move to a variable rate of interest that follows the base rate of interest by a certain amount.

When those two parties come together, a swap can take place.

Swap rates explained

Let's say a bank offers savers a 1% variable rate of interest on their money, so it borrows cash from them and pays them 1% in return.

The bank lends that borrowed money to a home buyer at a fixed rate of 3% over five years, so this means the bank can pay the saver their 1% and they make 2% profit.

However, if interest rates rise, the bank is forced to pay savers 2% to stop them moving their money to another bank, but because the home buyer is on a fixed rate of 3%, the bank's profit is reduced to 1%.

In order to protect itself in light of that lower profit percentage, the bank agrees with another financial institution to replace the variable cost it pays to savers with the fixed rate owned by the other party.

The other party is looking to replace its fixed rate with a variable rate, so the swap makes sense for both parties.

Interest rate swap rates

Swap rates in the UK, since May 2019, have fallen, although mortgage rates have remained largely unchanged while lenders wait to see what the outcome and BOE decisions are from Brexit.

Swap rates are essentially banks hedging their bets against what could happen to interest rates in two, three, five or 10 years.

If a swap rate rises, it means the financial experts think interest rates could go up and if a bank has to pay more, fixed rate mortgage products tend to become less attractive.

By checking swap rates as a homeowner, you can gain insight into whether a fixed rate or variable rate mortgage would be best.

If swap rates are high, generally a fixed rate mortgage would be better, while a low swap rate means a variable rate mortgage could save you money.

Things to consider

Swap rates aren't the only factor to consider when keeping an eye on your mortgage rate as often mortgage rates don't follow the swap rate when it rises.

That's because of simple competition for business between banks and mortgage lenders.

Always take independent financial advice when considering borrowing.

If you would like further advice, please don't hesitate to get in touch with your local CJ Hole branch.

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