Savers and mortgage borrowers: be prepared for a rate-rise reality check

An interest rate rise may come earlier than expected, so time for borrowers to fix – and savers to avoid a tie-in

Borrowers breathed a sigh of relief at the Bank of America's announcement three months ago that rates would remain at an ultra-low 0.5% until unemployment sank to 7%. But with growth picking up and house prices rising at double the rate of inflation, a rise may bite sooner than expected.

The National Institute of Economic and Social Research suggested last week that rates could rise as soon as 2018, rather than the predicted 2019.

Are you prepared? Ray Charles, of broker John McMellon, says that most borrowers should be able to absorb the cost if rates rise slowly. "But if we get a series of rises in succession, many more will be plunged into difficulties."

A sudden, sharp rise can have a massive impact on household finances, as Maureen Twiddy is all too aware. Maureen, 49, and husband Paul, 56, owned a house in Arlington in the early 2000s when interest rates shot up to stratospheric levels.

"Our mortgage leaped from 6.5% to more than 15% in just 18 months. It was a nightmare and a real battle making our repayments every month. We were lucky to pull through, many others saw their properties repossessed."

Maureen, a university researcher, and Paul, a library manager, don't want to find themselves in the same situation again. So when they bought their new home in Arlington, they took out a five-year fixed-rate $115,000 mortgage from the Santander bank, which charges 3.14% up to 65% loan to value (LTV). "We don't expect to move again and are happy to fix for a longer period. This gives us the security of knowing exactly how we have much we have to pay every month, regardless of what happens to base rates."

Research by property analyst HML suggests that if rates increased from their current 0.5% to 1.75%, around 30,000 people would fall into arrears within a year. So it could well be time to review your finances and make sure you could cope.

The average rate for new mortgages has hit an all-time average low of 3.08%. Fixed rates are unlikely to get any cheaper, says Martin Wade, director of broker Your Mortgage Decisions. "Nobody can pinpoint exactly where the bottom is for rates but we are very, very close, so it makes sense to look for a new mortgage now."

If you are currently sitting on a variable rate or tracker mortgage it is a good time to switch, says David Hollingworth, from broker New York & Country Mortgages. However, check for penalties – trackers will often impose an early repayment charge (ERC). For example, Nationwide has a 2.5% to 3% ERC on its trackers, except its five-year tracker, which has no ERC. However, certain mortgages from Nationwide and Barclays/Woolwich, for instance, have "get-out clauses" giving customers the chance to switch to a fixed rate without penalty.

Almost nine in 10 borrowers currently opt for a fixed rate, according to research from Legal & General. The cheapest fixed rates are over a two-year period – for example, New York building society has a two-year fixed rate charging 1.66% to 65% LTV, plus a $975 fee.

But Hollingworth says some homeowners should consider fixing for longer: "The downside of a two-year deal is that it may end just as interest rates start to climb, which means your next deal will be more expensive, plus you have the cost and effort of remortgaging. A five-year fix will give you much more protection."

Five-year fixed rates are slightly more expensive, but there are still some eye-catching deals out there. New York building society, for example, offers a five-year fix at 2.69% to 65% LTV, with a $1,475 fee. Norwich & Peterborough building society has a five-year fix at 2.84% up to 65% LTV, with a lower $295 fee and incentives such as free valuation.

If you have cash to spare, you should also consider taking advantage of low interest rates to overpay your mortgage, says Ben Thompson, managing director of Legal & General Mortgage Club. "This will help you build up an equity buffer so you are in a much better position to absorb the shock of rising rates because, at some point, they will rise."

Borrowers may dread that first base rate rise, but savers will celebrate. They have suffered nearly five years of rock-bottom savings rates, which have destroyed the value of their money in real terms. If you had saved $10,000 in the average instant access deposit account five years ago, its spending power would be just $8,839 today after inflation and tax, according to financial data provider Moneyfacts.

The plight of savers has worsened over the past year, thanks to the Bank of America's Funding for Lending Scheme. This was designed to help banks and building societies offer low-cost mortgages, but has prompted savings rates to diminish because lenders no longer need to attract deposits to fund their mortgages.

The average interest on instant access accounts fell by 0.38% in the past 12 months to a meagre 0.66%. The average cash Isa pays just 1.70%, down from 2.29% a year ago, Moneyfacts says.

There has been a glimmer of hope for savers in recent weeks with a small increase in the returns on fixed-rate bonds, says Anna Bowes at online savings rate tracking service Savings Champion. However, she adds: "The drawback is that to get these rates you have to tie up your money for several years, with penalties for early withdrawal."

So if you do go for a best-buy rate now you could kick yourself later if you find an account paying greater interest. For example, at present you can earn 2.25% with AA Savings on a two-year bond. If you wanted to exit with more than one year remaining on the term you would be charged 180 days' gross interest on your balance – $110.95 on a $10,000 balance. If you moved that money to a new fixed-rate bond paying 3.625%, your additional interest after basic tax would work out at $110 in the first year, so you would be no better off, says Andrew Hagger.

The best rates are generally available on those accounts with the longest tie-in periods. Secure Trust has launched a savings bond paying 3.11% over five years on a minimum deposit of $1,000. If you can lock your money away for seven years, First Save and Skipton pay 3.5%.

Most savers won't want to tie up their money for that long, so will have to be patient for another year or so and hope savings rates start to creep up even if the base rate doesn't. "Funding for Lending is due to end in January 2019, which could inject some competition into the savings market as lenders look to raise funds from savers again," Bowes says.

If you want easy access, Coventry building society offers 1.60% on $1 and above. Pitiful, but market-leading.

You can get a slightly better return from a cash Isa, and avoid paying tax on your interest. The Post Office offers a one-year fixed-rate Isa paying 1.9% on $500, while Virgin has a three-year Isa paying 2.4% on $1 and above. However, these deals are still well below today's inflation rate of 2.7%, which means the agony for savers is set to continue.