The incredible shrinking mortgage. How low can it go?

THE envelope is due to pop through Paul Murphy's letterbox any day now and he's hoping for some pre-Christmas cheer. Murphy, who works for a book publishing company in Edinburgh, is on a mortgage which tracks the Bank of England base rate. Recent and dramatic cuts in rates should see his payments halve.

When he took out the mortgage two years ago with the Manchester Building Society he was paying 5.49%. That has now fallen by around three percentage points, potentially saving him more than £200 a month if, as the Government intends, the full financial impact of the cut is passed on by the lender.

"I have to get the letter yet. We have been waiting for it for a while and we have been told we will get it the next week, but I am anticipating a fall in what I pay for my mortgage," he said. "When we remortgaged two years ago I thought of going on to a fixed rate, but eventually went for the tracker instead. I am very glad that I did."

Murphy, 30, is among the four million borrowers on tracker deals who should see their monthly payments drop by hundreds of pounds after the aggressive round of Bank interest-rate cutting in the past month to help the stimulate the economy.

Not every mortgage holder will be as fortunate. Those on their lenders' variable rate will reap some benefit depending on how generous their lender is inclined to be. Those who took a gamble on a fixed rate being a better deal will see no short-term benefit at all.

But the move to 2%, the lowest rate for 60 years, is expected to have a double impact: kick-starting the wider economy and shoring up one of the main props supporting the confidence of the British public – a healthy housing market.

For millions of homeowners, it cannot come too soon. In a year, house price values have slumped by up to 18% across the UK as whole and around 12% in Scotland as buyers, unable to get their hands on once-easy credit, have dried up as a result of the global credit crunch.

With Government policy no longer driven by the need to tackle inflation – as it was as recently as last summer – interest rates are being slashed to avoid deflation and a 1930s-style slump.

That rates are now at 2% – they have never been lower since the Bank of England set up for business in the 18th century – is astonishing in itself. The question now being asked in millions of households is simple: how low can it go? And can the cuts really rescue the housing market in 2009?

Some economists are predicting a further reduction to 1.5% as early as next month; others say the psychologically important 0% now cannot be ruled out if the Government wants to stop the recession from being both painful and prolonged.

So how low should interest rates go? Roger Bootle, the economic adviser to the accountants Deloitte, is among those who believe the Bank must cut interest rates "as far as it can". He predicted "It won't be long before interest rates are reduced to 1% and they may ultimately have to fall all the way to zero." There is a warning, however, that this will not mean free mortgages – the banks will still want to make some profit out of their customers.

Will cheaper money kick-start the housing market? The decline has been rapid and shocking after a decade in which house values had risen dramatically. In Edinburgh, the average price of a house rose above £200,000 more than two years ago and prices in other cities were beginning to catch up.

In some years house-price inflation touched 20%, contributing to a national feel-good factor as long as you were on the rungs of the housing ladder. A year ago, most areas of Scotland were still enjoying modest price rises. Housing market analysts observed the turning point in mid-summer when the banks, hit by the sub-prime mortgages scandal in the United States – with high-risk borrowers defaulting on loans en masse – started running out of cash. The housing market was among the first sectors to feel the effects of the credit squeeze and severe restrictions on mortgage lending.

David Marshall, a business analyst at the Edinburgh Solicitors' Property Centre, predicts that house-price values in Edinburgh and Lothians area – once the gold standard by which property prices in Scotland were judged – will have fallen by at least 12% by the end of the year.

"Prices were continuing to rise until July, but since then there has been a sharp downward shift in the market. Transactions are down by up to 60% and the average price of a property will have fallen by 12% over the year.

"That price will be down below the £200,000 mark that it first went over in May 2006. As we had many years of 10% growth, sometimes as high as 20%, it is perhaps better to see it in that context."

Mark Hordern, marketing manager at the Glasgow Solicitors' Property Centre, which covers all of west central Scotland, is another expert who has observed the housing barometer plunging for the first time in a generation.

"We recorded a fall in house prices in the west coast of 8% in the year up to October and we expect it will fall by 12% by the end of the year. It is still below the UK average, but it is still a significant drop."

The reduction in the number of buyers – which means that with reduced demand houses sell for less – appears to be countrywide. Property agents Pagan Osborne says prices have slipped by up to 15% even in former hotspots such as St Andrews, where its university-town status and reputation as the home of golf, were responsible for driving up prices. "Local surveyors are valuing properties at 2006 prices," said spokeswoman Linda Black.

"We are going out every day and saying to clients that their properties are not valued at the same level as they were in March or April this year. If they put them on at the April price, they will not sell. It is as simple as that."

Last week's 1% cut followed a 0.5% cut in October and the surprise 1.5% reduction last month. Whether there are more depends on how worried the Bank of England is about the wider economy and not just the housing market. And with firms across the country tightening belts and laying off staff, economic confidence is an extremely fragile flower.

Ross Walker, the UK economist with the Royal Bank of Scotland, said: "We have certainly got further interest rate cuts to come. The latest economic survey data shows conditions are still deteriorating and many at a more rapid pace than before. All the indications are that in the fourth quarter of 2008 gross domestic product will be in greater decline than in the third quarter. The first quarter of 2009 will not be much better.

"There is likely to be a move to 1.5% interest rates, perhaps in January, and there is no sense that will be the end of the process. As for going to 0%, well you cannot rule anything out. Twelve months ago we would have said there was only a miniscule chance of rates getting down to 2%, but it has happened. I think we will settle above 0%, but whether that is 0.5% or 1% I just don't know at this stage."

Even if the unprecedented 0% base rate figure is reached, economists point out that it won't mean zero payments. As mortgage rates are typically set above the base rate, borrowers will still have to fork out a certain amount every month.

In any case, there is still some way to go. Although seven out of the top-ten lenders in the UK have announced full or partial rate reductions following last week's base rate cut, three – Northern Rock, Abbey and Alliance & Leicester – say they have yet to make a decision. This week, the Chancellor is expected to meet bank chiefs again to ram home the Government's message that all banks are expected to comply.

Analysts say there is another factor more likely to put smelling salts under the nose of the ailing housing market. Although borrowing rates have fallen and may drop further, buyers will only return once banks start lending again. By early next year, they say, the billions of pounds of 'bail-out' cash that the Government is investing in major mortgage lenders such as HBOS should be trickling through into the wider financial markets.

"A lot of the money promised to UK banks has not arrived yet," said Hordern. "There are legal hurdles to overcome. HBOS is in for £12bn and they haven't got a penny as yet. RBS is getting £15bn, but they haven't seen it yet. Early next year they will get those funds, which will allow them to lend more.

"So as the year progresses, there will be further reductions in the cost of mortgages and an improvement in liquidity in the banks. When mortgages are cheap and house prices are very good value due to the recent falls, buyers will come back into the market and demand will rise sharply. There could even be a scramble later next year as they try to get in while bargains are still to be had."

Even in the Edinburgh area, however, where the housing market has proved resilient in the past because of its once-booming financial sector, house prices are expected to fall further before any sign of recovery.

"There should be more buyers in the new year because as prices fall, houses become more affordable," Marshall said. "But I don't think there is likely to be any house price growth at all in 2009."

There is a strand of opinion, meanwhile, that believes a downward readjustment of house prices is no bad thing. On Tuesday, the Centre for Confidence and Wellbeing in Glasgow is holding a seminar entitled 'Thriving in Turbulent Times'.

The centre's chief executive, Carol Craig, explained: "There is no getting away from the fact that we are entering a painful recession but, in my view, we need to keep this in perspective. We have come to believe that houses are an investment rather than a place to live. The trajectory of price rises that houses were on was unsustainable in the long term. More money does not necessarily mean more happiness and I think people have started to realise that."

For Paul Murphy, it is simply a matter of crossing his fingers that the mortgage rate cuts will materialise as promised: "It will help financially, although I've yet to find out by how much." He admits, however, that he won't be spending the extra cash, much as the Government would like him to as part of its attempts to revive consumer spending. He's taking a sensible option: "I don't think I'm going to rush out and spend it all. This time I am going to save."

What type of deal is best right now?

With so much confusion in the mortgage market, many homeowners are unsure of the best deal. Here are some tips from Stephen Stoops, of Conquer Mortgage Services.

First-time buyers/new mortgages:

The big question is fixed rate or tracker. But rates will rise again so I recommend fixed rates. They may be a little more expensive in the short term, but long term I think they will be better.

Existing customers coming off tracker or fixed rates:

Depends on whether your lender is passing on the full interest rate cuts. Ask what alternative rates they have to offer then see if an independent mortgage adviser can better it. Except in the case of Northern Rock, it will normally be better to stay with the existing lender.

Existing customers tied into a deal:

Stay put as the often substantial financial penalties mean it will not be worthwhile for the amount you might save on monthly repayments.

Buy to let:

I have been saying to a lot of people now that if they have cash buy property, values are falling but once the property market returns it will return with a bang. The problem with buy to let is finance, the maximum loan-to-value is 75%, the rates are not that great and the rental income calculator used by many lenders means they don't stack up for lending purposes.

New-build:

Lenders will not lend on new-build flats for buy-to-let purposes and only up to 75% for a main residence. However, some builders are offering shared equity, which allows the buyer to purchase the property for 75% of the total cost, for which some lenders are happy to provide a 100% mortgage. The buyer can later purchase the outstanding sum.

Stephen Stoops, independent mortgage adviser, Conquer Mortgage Services, www.conquermortgages.co.uk