Borrowers lulled by the ECB's reluctance to raise rates should be aware the credit crunch is likely to push up variable rates, writes Caroline Madden

Each time the governing council of the European Central Bank (ECB) meets to decide whether or not to tinker with interest rates, homeowners await the outcome with bated breath, aware that their monthly mortgage repayments will be affected by the decision.

The fact that Jean-Claude Trichet and his governing council colleagues have not announced a rate hike since last June has lulled borrowers into a false sense of security.

Although the ECB rate has flatlined at 4 per cent for the last six months, several Irish banks have recently raised their mortgage rates and other lenders are expected to follow suit. Why? It all comes down to the infamous "credit crunch".

Due to the global liquidity crisis, the cost of borrowing money on the interbank lending market - or wholesale money market - has shot up. Basically, it is costing the banks more to borrow money that they then lend on to you at a profit.

Eamonn Hughes, a bank analyst with Goodbody Stockbrokers, says Irish banks initially absorbed the increased cost of borrowing funds, but not any more. "They were just trying to get a sense of whether this was temporary or longer-term," Hughes explains. "It's certainly lasting a lot longer than people anticipated, so now they're starting to pass it on."

This means that the ECB rate is not the only, or even the main, driver of mortgage rate changes at the moment. "While we've all been conditioned to watching the ECB base rate as the driver of retail interest rate changes, the latest development just copperfastens the message that it really is all to do with the wholesale money market," says Felix O'Regan, spokesman for the Irish Bankers' Federation.

"The cost of money from the wholesale money market has been increasing for lenders and that, in turn, is driving up the rates."

Fortunately not all mortgage holders will be affected by the rate increases. Borrowers with fixed-rate home loans are immune to such changes, as are existing customers who have already taken out tracker mortgages, as their rate is set at a fixed percentage or "margin" above the ECB rate.

However, borrowers who have signed up for standard variable rate mortgages may be exposed, because banks are free to alter the rates applied to these loans. New tracker mortgage customers, including first-time buyers, may also feel the pinch as banks widen the margin above the ECB rate that they may charge. Davy bank analyst Emer Lang says that, until recently, most banks were biding their time to see what their competitors did. "Nobody wants to be the first to push up mortgage rates, and certainly not to push them up significantly because all you do is choke off demand in a market that's already under lots of pressure," Lang explains.

However, in December, Ulster Bank bowed to the pressure of tightening margins, and increased its standard variable rate for existing customers to 5.7 per cent APR (annual percentage rate).

Last month, Permanent TSB raised its tracker rates and, on Tuesday, AIB, which has been one of the most competitive mortgage providers over recent years, increased its standard variable rate to 5.25 per cent.

So far, the increases have been between one-tenth and one-quarter of a percentage point. Against the backdrop of significant increases in funding costs, these hikes are quite moderate. The competitiveness of the domestic mortgage market, and a glimmer of hope that wholesale rates will return to more normal levels, has so far deterred lenders from passing on the full costs. But for how long?

And, now that four banks have shown their hand, will the floodgates open? Timing is really the key issue, Lang says. "Some will try and hold out as long as they can to give themselves a competitive advantage in a market that's pretty quiet at the moment."

Paul Short, president of the Irish Mortgage Advisers' Federation (IMAF), agrees that some banks may hold off temporarily, but says that as long as the cost of funding remains at its current level, it is inevitable that more lenders will follow suit.

Ultimately banks will have to "cover themselves", he says. Their profit margin on money lending at the moment is "pretty well negligible", so they will have to move to alleviate this.

Before Christmas, Bank of Scotland Ireland signalled to brokers that it may amend the pricing on its tracker mortgages for new customers, but a decision has yet been made on this.

Bank of Ireland is keeping a close eye on the market, but hasn't announced a definite course of action yet. EBS says it has "no immediate plans" to increase either its standard variable or tracker rates. Meanwhile, a spokesman for AIB commented that, given the current market environment, an increase in tracker rates during the year "would not be unexpected".

The latest EBS/DKM affordability index indicated that affordability for first-time buyers improved over the past year, but this trend could well reverse in light of recent mortgage market developments. The mortgage interest relief rise announced in the budget was very welcome, but will be offset to a certain extent by higher mortgage rates.

The recent overhaul of the stamp duty regime was expected to boost the purchasing power of first-time buyers by reducing the upfront cost burden.

However, lenders are now either curtailing or pulling back entirely on 100 per cent mortgages, which means that first-time buyers will once again need to save a significant lump sum in order to get onto the property ladder. "Banks are taking a more jaundiced view of them," says Short. "They're certainly becoming very, very discerning as to who they will consider for 100 per cent mortgages."

Banks are also starting to shy away from previously popular marketing ploys such as discount rates, which were typically offered to first-time buyers or new customers. These allowed the borrower to avail of artificially low repayments for an initial period, usually a year, after which time the mortgage would revert to a normal fixed or tracker rate. "Withdrawal of the discount rates has been due to the credit crunch," says Short.

So is there any light at the end of the tunnel? Nobody is willing to make a call as to when exactly things might start returning to normal, as there is still so much volatility and uncertainty in international financial markets.

However, there is a view that fourth-quarter earnings results being reported currently by major US and European banks will bring a certain amount of clarity to the situation. The figures from the institutions that have reported this week give little comfort.

Lang says that there is a lot of nervousness surrounding these results. "The entire fourth-quarter earnings season is regarded as a bit of a watershed," she says. "We certainly think things will be choppy for the first couple of months until all of the earnings figures are out there."

The only thing that seems certain in the current environment is that borrowers shouldn't place too much confidence in the ECB rate - at least until the credit crunch eases.

Switch on to savings

Mortgage rates may be rising and introductory discount rates becoming a thing of the past, but borrowers can still benefit from shopping around and weighing up the pros and cons of switching to a different lender.

The latest figures from the Irish Bankers' Federation confirm that switching is becoming increasingly popular among mortgage holders. In the third quarter of 2007, switching activity accounted for 17.4 per cent of all new mortgage lending by volume.

According to Paul Short, president of the Irish Mortgage Advisers' Federation, some very attractive switching offers are currently available in the market. "They've caused greater competition in the marketplace which is good for everybody," he says.

In a bid to entice borrowers away from their existing mortgage providers, lenders are dangling an assortment of tempting terms in front of prospective customers. These range from offers to cover the legal costs involved in switching mortgage to generous upfront cash payments, and of course promises of significant savings on their repayments.

EBS, for example, is currently advertising that it will pay a cash bonus of €1,000 to homeowners who avail of its QuickSwitch mortgage product. The institution doesn't charge switching fees and is also promising to cover legal costs, as long as the new customer chooses a solicitor from the EBS QuickSwitch panel.

As always it's vital to read the fine print of such offers. EBS's offer only applies to customers approved between January 7th and February 15th.

Also if the customer decides to move their mortgage to another institution before the end of a five-year period, they will have to repay €777 to EBS.

In many cases, lenders are targeting their switcher products at people who have built up some equity in their home, and have a low loan-to-value (LTV) rate. This means that the size of their mortgage is less than the value of their home.

For example, an individual who borrows €200,000 and whose home is valued at €400,000 will have an LTV rate of 50 per cent.

"Some lenders offer lower variable and tracker rates if your LTV ratio is below a certain level, such as 60 per cent," says the Irish Financial Services Regulatory Authority.

Short advises borrowers to shop around for more competitive rates, but rather than switching mortgage immediately, bargain with your existing lender and try and secure a better deal with them.

"Some of them will respond more readily than others to try and hold the business," he says.

And, remember, at the end of the day inducements should not cloud the core issue - the actual mortgage rate / tracker margin with the new provider.