Protect your mortgage from interest rate hikes

For over a year now, anyone on a tracker mortgage has enjoyed incredibly low interest rates. Many people are paying just one percentage point above the base rate of 0.5%. And those lucky borrowers who took mortgages out with Woolwich and Cheltenham & Gloucester in 2006 and 2007 are on rates of just 0.17 points over the base rate. But how can you protect yourself if interest rates rise and leave you facing far bigger monthly repayments?

One option is mortgage insurance. The Interest Rate Protector, launched last week by mortgage advisers John Charcol, pays part of your mortgage repayments if interest rates rise above a set level. It's not the first product of its kind, but is drawing a lot of media attention.

The Interest Rate Protector is for people with mortgages of over £500,000 who are not on a fixed-rate deal. If you buy, say, five-year protection on £500,000, you will pay a premium of around £17,500 for a Bank of England base-rate cap at 3%. So if you have a tracker rate of 0.5% above the base rate, the policy will cover any increase in your mortgage payments above a 3.5% rate. The higher you set the cap rate the lower the premium you pay.

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Fine, but that's quite an outlay given no one knows when or if interest rates will rise. Charcol may think rates will start rising next January, but other experts think it will be later next year.

However, if you are convinced rates will rise soon then mortgage insurance could be better value than going for a five-year, fixed-rate mortgage. The best five-year fixed rate available at the moment is 4.15% from Yorkshire building society. But before handing over a large, non-refundable premium, consider the other ways to protect yourself.

If you have £17,500 available for mortgage insurance, why not put that money into a savings account with the highest possible interest rate? You can then dip into the pot to pay any extra mortgage interest if rates go up.

Or you could opt for a capped-rate mortgage. Coventry building society has launched a three-year capped tracker at 2.5% above the base rate, with a 4.99% cap. So right now you would pay 3% (0.5% + 2.5%), safe in the knowledge that if interest rates rise you won't pay more than 4.99% for the duration of the mortgage.

Finally, you could opt for a base-rate tracker mortgage with no early repayment charge. Then if the base rate starts to rise to unaffordable levels, you can switch to a fixed-rate mortgage without penalty.