The extensive media coverage of the credit crunch in recent months is likely to have done one of two things for you (aside from possibly causing your monthly repayments to rise): either forced you to get your head around how the market actually works, so you know what’s going on and can keep up to date with the news; or reinforced your existing lack of knowledge and potentially caused you to bury your head in the sand when it comes to all things financial.

Articles discussing issues such as the lack of availability of ‘cheap’ mortgages, the effects of rising interest rates on mortgages or the pricing of credit, may often hinge on the reader’s understanding of terms such as LIBOR, Bank of England Base Rate and swap rate – terms which, although not exactly new to the public domain, may not be understood by the general reading and TV-watching public.

Base Rate

In short, rises and falls in the Base Rate, LIBOR and swap rates are largely reflected in the pricing of mortgages, because these rates impact how lenders fund their mortgages.

Where to begin? Press coverage of inflation and the cost of mortgages often refers to the Bank of England Base Rate. The Base Rate is the UK’s main interest rate and is set each month by the Monetary Policy Committee (MPC). The level at which it is set (it was maintained at 5% at the last MPC meeting on 8 May 2008) is dictated by the committee’s attempts to balance inflation and economic growth, taking into account various factors, such as unemployment levels and the housing market.

LIBOR

When Abbey reduced the rates on its entire tracker mortgage range and some of its fixed-rate mortgages by 0.05% a few weeks ago – after having already reduced its products by 0.10% following the introduction of the Bank of England’s special liquidity scheme – it cited anticipated falls in LIBOR as one of the two main reasons for doing so.

But what on earth does LIBOR mean? Is it related to Base Rate – and how does it affect the cost of mortgages? “LIBOR refers to the London Interbank Offered Rate – the interest rate at which banks borrow money from one another,” says Katie Tucker, technical manager at mortgage broker John Charcol. “It is set at the end of each day and is basically an accidental average of the rates at which banks agreed their deals throughout the day.”

Michelle Slade, spokesperson for price comparison site Moneyfacts, explains the relationship between LIBOR and Base Rate: “Base Rate is the bench mark for the rate of lending. When banks wish to borrow money they may go, among other things, to the LIBOR markets. If a Base Rate increase is expected the demand for cheap borrowing could result in the increase of the LIBOR rate.

“The banks lend out the money they obtain on the LIBOR market in the form of mortgages or other lending, making a margin on top of the rate they borrowed at. If the rate they borrow at increases, so do mortgage rates.”

So, we’ve established that banks lend money to one another and charge each other interest for doing so. The interest rate at which they agree to lend each other money is the LIBOR rate and this can increase when the Base Rate is expected to rise and vice versa if it is expected to come down.If a lender’s costs of funding its mortgages increase, as they will do if the Base Rate and/or LIBOR increases, then the interest rates on mortgages will usually rise too.If the Base Rate and LIBOR come down, then in theory at least, the cost of mortgages should come down as well.

But what about those three decreases in the Base Rate – have they not helped to bring LIBOR, and thus, the cost of mortgages down? “There is a fundamental supply and demand problem when it comes to funding at the moment,” says Tucker. “When the Bank of England injected £50bn into the system, there was some optimism about things getting better. But when the Government revealed that inflation had reached 3%, many lenders took the opinion that in order to rectify this, Base Rate will not be coming down by as much as was previously expected.”

Because lenders don’t foresee Base Rate coming down significantly, LIBOR hasn’t come down, as lenders still want to be cautious about their borrowing. This means that there hasn’t been a widespread decrease in the cost of mortgages in line with the reduction in the Base Rate.

Swap rates

When it comes to fixed-rate mortgages, it is a slightly different story. Fixed-rate mortgages are funded using swap rates. “Swap rates reflect what banks are betting the Base Rate will be by a certain time. That period of time can be one, two, three and five years, and corresponds to the fixed-rate period of the mortgage,” Tucker explains. So, for example, if two-year swap rates go up by 1%, it will usually be because those banks lending money to one another believe that the Base Rate will increase by that much, over that period of time. This, of course, means that because lenders’ funding costs increase when swap rates go up, it is likely that the cost of their fixed-rate mortgages they offer will too. Nationwide recently made a range of reductions to its two and five-year fixed-rate mortgages, on the basis that swap rates for these periods had come down.

Mortgages are complex products and although it isn’t a necessity for borrowers to be able to recite a definition of LIBOR at the drop of a hat, knowing how the market works could, at the very least, ensure that the next time you read a jargon-riddled article, you might stand a better chance of knowing what they’re going on about. If you didn’t already, that is.