Economic theories at a glance

The lenders interest charges associated with mortgages are based on the Bank of England's (BOE's) base rate. The BOE's Monetary Policy Committee holds a meeting every month to decide whether or in what way they will change the base rate. Changing the base rate is a monetary policy used to influence consumers spending and borrowing habits. By increasing the base rate consumers will find saving money in their bank accounts more attractive, but borrowing will become more expensive, so people are likely to save rather than spend. This is a method used to reduce the rate of demand-pull inflation, but it can have serious implications for mortgage holders. When the BOE changes the base rate other lenders must follow suit by changing their standard variable rates. Many borrowers may find themselves struggling to repay their mortgages if the BOE decides to increase the base rate as it announced it would on the 12th of March 2004. Inflation needs to be limited because it can have a negative affect on real money values affected by other interest rates. If the rate of inflation rises above the average rate of lending it will cause problems for lenders because borrowers will be borrowing money with no real interest charge. This is because the money they owe is decreasing in real terms at a faster rate than the interest charge they must pay to lenders. In the same way any money in savings that has a lower interest rate than the current rate of inflation will be eroded in real terms because it will pay for less after a period of time because its growth will have been slower than inflation. Inflation can also erode the real value of fixed incomes such as pensions, because fixed incomes will have less purchasing power as inflation occurs.

The BOE can also change their minimum cash ratio, and all other lenders must do the same. The minimum cash ratio describes the value of cash and liquid assets the lender owns in relation to deposits. If the minimum cash ratio is increased lenders will have less ability to provide credit for borrowers because they will not have as many liquid assets in ratio to deposits. Inflation and monetary policy affect mortgage lenders ability to provide credit and the real income lenders receive from interest and capital repayments. If inflation is high mortgage lenders may lose some of the real value of their investment. This also has an affect on investment vehicles, such as pension plans, that are used by borrowers to repay their mortgage capital.