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PERSONAL FINANCE: How does the help to buy interest rate work?

by Paul Morgan

The Real Costs and Risks of ‘Help to Buy’ Revealed

Last week, I discussed the potential risks of interest rates reaching seven percent or higher and how this would impact stress testing. Within that column, I also highlighted the risks associated with the ‘help to buy’ scheme, specifically focusing on the fact that 40 percent of those participating had a disposable income of less than £40,000. The concern was that borrowers would eventually be forced to refinance the debt scheme, but at a time when borrowing costs and the ability to borrow may be too high. It appears that we have now reached that point.

Since last week’s column, I have received numerous calls and emails regarding interest rates and the costs associated with the ‘help to buy’ scheme. This article aims to address those concerns and shed light on the true costs of the scheme that are often poorly communicated.

One of the main worries for borrowers is the new interest rate they will have to pay on the amount borrowed from the government. Around 380,000 people have utilized this scheme, which was introduced in 2013 to assist individuals in getting onto the property ladder. The ‘help to buy’ scheme allows borrowers to borrow up to 20 percent (or 40 percent in London) of the purchase price from the government.

For the first five years, there is no interest charged on the borrowed amount. However, after this initial period, borrowers are required to repay both the mortgage and the interest on the loan. This is where the confusion arises. The government website states, “In the sixth year, you’ll be charged interest at a rate of 1.75 percent. The interest rate increases every year in April, by adding the Consumer Price Index (CPI) plus two percent.”

Upon reading about the scheme on various websites, it is evident that the wording is the same across all sources. Consequently, most borrowers would understandably be concerned about the potential costs based on this wording.

Considering that the CPI currently stands at 6.4 percent, borrowers may mistakenly calculate the interest rate by adding this figure to the initial 1.75 percent and the additional two percent. This would result in a total interest rate of 10.15 percent, significantly higher than the zero percent they were paying for the first five years. Many individuals whom I asked to read the government website came to the same erroneous conclusion.

However, this is not the case. The interest rate is actually calculated by adding the CPI and two percent, multiplying this figure by 1.75 percent, and then adding it to the initial 1.75 percent. Yes, it’s rather mundane. Using this method, the interest rate for the next year would be 1.897 percent. Each subsequent year, this rate will increase by the CPI plus two percent.

As time goes on, borrowers may find this interest rate to be burdensome and costly, especially as interest rates decrease. Currently, with high inflation and high interest rates, this is not a pressing issue. However, in the future, borrowers may start to view the 1.897 percent rate and subsequent increases as excessive.

Additionally, if property prices rise while borrowers are participating in the scheme, they will lose out on the growth of the property based on the percentage they have borrowed. For example, if a borrower has borrowed 20 percent for a property originally worth £200,000, they would have borrowed £40,000. If over the course of five years, the property value increases by 30 percent to £260,000, the total value owned by the government would be 30 percent (£60,000), leaving the borrower with the remaining portion (£56,000).

When it comes to interest payments, borrowers will only pay interest on the original borrowed amount (£40,000), not the total value owed to the government (£56,000).

The optimal time to consider refinancing the loan is when interest rates are lower and before property prices start to rise again.

As I mentioned in 2018, “To exit such a scheme, careful planning, with one eye aimed at future economics, will be key.” This statement still holds true.

In conclusion, the ‘help to buy’ scheme has its costs and risks, especially as interest rates increase. Borrowers must closely evaluate their financial situation and plan accordingly.

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