Base rate set to rise by May

With inflation soaring, the base rate will soon rise. Will you win or lose from higher rates?

As my lovemoney.com colleague John Fitzsimons warned yesterday, the inflation rate has rocketed to 4%. 

That's twice the Bank of England’s target of 2% a year - which means the Bank will soon have to act. Within months, the Bank’s Monetary Policy Committee (MPC) is likely to increase the base rate from its record low of 0.5%, where it’s been stuck since March 2009. 

Mervyn King, Governor of the Bank of England, said he expected inflation to hit 5% in the next few months, but to return to around 2% within two or three years, "under the assumption that bank rate increases in line with market expectations".

Markets expect the base rate to rise to at least 0.75% in May, followed by another quarter-point rise every quarter until 2013.

Today, Mr King stressed that the decision to raise rates has not yet been taken. He said it "won't be taken until we get to the next meeting or the following meeting, or it may be many quarters."

But he added: "It is clear that at some point the base rate will have to go up. Anyone making long-term financial decisions should not expect the base rate to be at these low levels indefinitely."

By raising the base rate -- probably via a drawn-out series of 0.25% hikes -- the MPC would aim to snuff out inflation before higher pay demands lead to a vicious circle of higher wages and higher prices. (Always remember that one worker’s pay rise is another worker’s price rise.)

Get ready for higher interest rates

Thanks to differences of opinion at the nine-member MPC, it still far from clear exactly when and how the base rate will start to climb. Nevertheless, based on the forecasts in financial markets, a rate hike in the next six months is almost a dead cert. It may even happen by May!

Hence, we Brits should brace ourselves for a higher base rate and, therefore, higher interest rates across the board. But who will be the winners and losers from higher rates -- and how can the losers fight back?

How to beat higher rates

Let’s take a look at five groups that need to react to rising rates, including some winners and some losers:

1.     Homeowners (losers)

With over half (53%) of our net wealth tied up in property, we Brits are naturally obsessed with all things housing. However, once the base rate starts to rise, mortgage rates are sure to follow suit, making buying a home more expensive and thus putting prices under pressure.

What’s more, anyone with a tracker mortgage or variable-rate loan linked to the base rate will see immediate increases in their monthly payments. Each 0.5% rate hike on a £100,000 interest-only mortgage costs another £500 a year, or almost a tenner a week.

Thus, my advice to homeowners -- especially those with hefty loans -- is simple: shop around to make sure that you have the ideal home loan, as well as the ideal home.

What if you’re on a low tracker rate and don’t want to switch until interest rates actually start to rise? Consider booking a cheap fixed rate now (offers remain valid for six months in many cases) just in case you need it later. Read The sneaky mortgage trick to save you money to find out how to do this.

2.     Borrowers (losers)

While mortgage rates have fallen dramatically in the past two years, the cost of unsecured (non-mortgage) borrowing has gone up.

At the peak of the credit boom, borrowers with high credit scores could get personal loans at interest rates not much above 5% APR. Today, the APR on a Best Buy personal loan will be at least 2% higher, largely because rising bad debts have made such lending riskier.

Even worse, the interest rates charged by credit cards have repeatedly risen since the credit crunch which began in August 2007. With a typical credit card now charging 18.9% APR on purchases, card rates are at a 13-year high.

If you have expensive debts on plastic, you should ‘stop the clock’ on your interest bill. By using balance transfers, you can avoid interest for up to up to 17 months, in return for a one-off fee of 2.9%. That’s miles better than borrowing at rates of 1.5% a month!

3.     Savers (winners)

The group set to benefit most from higher interest rates are Britain’s savers, who have been battered by three years of falling savings rates. As the base rate starts to rise, Best Buy savings rates will follow suit, helping to boost the returns earned by cash deposits.

Although headline rates for new customers will rise in step with the base rate, banks and building societies drag their heels when it comes to hiking rates for tens of millions of existing savers. So, don’t lose out because of loyalty. Instead, use the base-rate rises as a spur to switch accounts and boost your savings rate.

4.     Pensioners (winners)

As most Brits pay off their home loans before retirement, pensioners don’t bear much of the UK’s £1,234 billion mortgage mountain. Similarly, their other debts are much lower than average, so they shouldn’t worry about the rising cost of borrowing on the UK’s £227 billion of consumer credit.

Of course, retired folk often keep large sums in cash in order to earn interest to boost their incomes. Hence, as the UK’s most fervent savers, pensioners are likely to do well as rates rise. However, those who don’t chase the best rates are likely to be left at the mercy of rip-off savings accounts. So, make sure your Gran and Grandad (or Mum and Dad) don’t lose out as rates rise.

Also, as long-term interest rates rise, so too will annuity rates. With the retirement incomes paid by insurance companies set to go up, future pensioners will get higher incomes when they hand over their pension pots in return for lifetime payouts.

5.     Investors (winners and losers)

With the headline FTSE 100 index roughly where it was 13 years ago, British investors and ISA owners have had a tough time since the turn of the century.

As the base rate starts heading north, it will become gradually more expensive for companies to borrow money. While this won’t be a problem for global Goliaths such as BP, Vodafone Group or GlaxoSmithKline, rising rates will put pressure on smaller companies, especially those labouring under heavy debt burdens.

Thus, I suspect that rising interest rates will pile more pressure onto small companies, while large and cash-rich firms will be largely unaffected and could even benefit. Therefore, investors may need to take a close look at their portfolios to see which companies and shares could come under pressure as the rate cycle turns. Alas, last year’s star all too often becomes this year’s dog!

How will higher rates affect you? Please tell us in the comments box below...

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