Jeff Salway: Beware what you wish for as interest rate hike could spell bad news

Next month will mark two years since the Bank of England lowered interest rates to 0.5 per cent, but for many people it will feel like even longer.

Interest rates started tumbling in the second half of 2008, so we have already had two and a half years of diminishing returns from savings accounts. For some people, particularly those on a fixed income, such as pensioners, the impact has been devastating, with rising inflation eating into their savings.

So the prospect of an interest rate rise over the coming months, which moved a step closer when the latest inflation figures were published yesterday, should, in theory, be cause for optimism. There is a growing belief that we will move up from the current 0.5 per cent base rate by time summer arrives, with an increase of either 0.25 or 0.5 per cent.

For long-suffering savers, the logic goes that any increase will boost the returns they are offered on their savings. Some argue that higher interest rates will force banks and building societies to step up their competition in the savings market in an attempt to attract more deposits with which to lend at more generous margins.

That may not be the case, however. It may not feel like it, but that need for lenders to attract customer deposits means the margins on savings are already at a rare high. A clue to the extent of the clamour for deposits can be found in the savings best-buy tables, which currently feature high street names, including Lloyds and Santander.

These tables used to be dominated by savings specialists and building societies, with the big banks relying on the money markets for their lending funds.

However, those markets remain severely restricted so the banks are now turning to savers. That has caused the gap between savings rates and the base rate to steadily widen.

A look back at interest rate movements over the past three years underlines this. In February 2008, with interest rates at 5.5 per cent, the average easy access account paid 4.04 per cent and the average cash Isa 5.29 per cent. Above inflation, but below the interest rate.

When the base rate fell to 4.5 per cent the average easy access and cash Isa rates in November that year were 4.71 and 4.5 per cent respectively, according to Moneyfacts.

Then we had a series of substantial interest rate cuts. When the base rate dropped to 3 per cent in December 2008, the average cash Isa paid 3.37 per cent and the average easy access account offered 2.55 per cent. Two months after the base rate fell to 0.5 per cent, the average easy account paid 0.64 per cent and the average Isa 1.92 per cent.

Those averages are now 0.84 and 2.27 per cent, respectively.It doesn't sound like much, but when you bear in mind that these are averages - the best buys are around 2.7 per cent for easy access accounts and 2.9 per cent for cash Isas, while fixed rate bonds are higher again - it's clear the margins are far higher than providers want to offer.

Traditionally, they would pay around or just below the base rate, but now they are offering rates well above it. So what will they do when interest rates rise?

Despite the demand for customer deposits, it seems very unlikely that a 0.5 per cent increase in the base rate will be reflected in savings account offerings.

There may be a small increase, but most deals will remain unchanged and several providers will even take the opportunity to reduce their margins. Therefore, if inflation remains around the current level, higher interest rates will offer little succour for savers.

However, for homeowners on variable rate mortgages, lenders will have no problem with passing on any rise in interest rates in full. An increase of 0.25 per cent would see repayments on a 150,000 tracker mortgage of 2.2 per cent (the average of the top trackers currently on the market) rise from 650 a month to 669. A 1 per cent increase would see it jump to 727.

Many homeowners have made substantial inroads into their loans while repayment rates have been low, so an increase should not be a threat. Yet with household finances under pressure from inflation, pay cuts, unemployment, tax rises and benefit cuts, even a small interest rate hike could spell bad news for both homeowners and savers.