Mortgage Rates Fall to 4.2%: Are We Finally Past the Peak of the Cost of Living Crisis?

Mortgage rates have fallen significantly from their 2023 peaks, offering a glimmer of hope to homebuyers and the 1.6 million homeowners facing remortgaging in 2025. The average two-year fixed rate has dropped to 4.2% in January 2025, down from 6.1% in October 2023, while five-year fixes have fallen to 3.9%, according to Moneyfacts data.

The decline reflects cooling inflation, expectations of Bank of England rate cuts, and increased competition among lenders. For a borrower with a £200,000 mortgage, the fall from peak rates saves approximately £230 per month—a meaningful relief after two years of cost of living pressures. However, rates remain well above the sub-2% levels available during the pandemic, and many homeowners remortgaging in 2025 will still face significant payment increases.

Why rates have fallen

Mortgage rates are primarily driven by two factors: the Bank of England base rate and lender funding costs. The base rate, currently at 5.25%, influences the cost of borrowing for banks, which they pass on to mortgage customers. Lender funding costs—what banks pay to borrow money from wholesale markets or depositors—also affect the rates they can offer.

The sharp rise in mortgage rates from late 2021 to late 2023 was driven by the Bank of England's aggressive interest rate increases to combat inflation, which peaked at 11.1% in October 2022. The BoE raised the base rate from 0.1% in December 2021 to 5.25% by August 2023, the fastest tightening cycle in decades.

Mortgage rates initially lagged behind base rate rises, as lenders were slow to pass on higher costs, but by mid-2023 they had caught up and even overshot. The average two-year fixed rate peaked at 6.1% in October 2023, driven by market turmoil following the short-lived Truss government's unfunded tax cuts, which spooked bond markets and drove up lender funding costs.

Since then, rates have fallen as inflation has cooled—dropping to 2.3% by December 2024—and the Bank of England has signalled that rate cuts are likely in 2025. Markets now expect the base rate to fall to around 4% by the end of 2025 and 3% by 2026, and lenders have priced in these expectations by reducing mortgage rates in advance.

Increased competition has also played a role. With house prices falling and transaction volumes down, lenders are competing aggressively for customers, offering lower rates and cashback incentives to attract business. Some lenders, particularly building societies with lower funding costs, have cut rates below 4% for borrowers with large deposits.

What the rate falls mean for borrowers

For homebuyers, the fall in mortgage rates improves affordability, though the impact is modest given that house prices remain high and rates are still well above pre-pandemic levels.

A first-time buyer purchasing a £250,000 property with a 10% deposit (£25,000) and borrowing £225,000 over 25 years would pay approximately £1,220 per month at a 4.2% rate. At the October 2023 peak of 6.1%, the same mortgage would cost £1,460 per month—a saving of £240 per month or £2,880 per year.

However, compared to the sub-2% rates available in 2020-2021, the same buyer would have paid around £950 per month, meaning current rates are still £270 per month (£3,240 per year) higher than pandemic-era levels. Affordability has improved from the 2023 peak, but it remains stretched by historical standards.

For remortgagers, the picture is more complex. Over 1.6 million homeowners are due to remortgage in 2025, according to UK Finance, and many will face significant payment increases even at current rates.

The majority of these borrowers fixed their mortgages in 2020-2021, when rates were at historic lows. A homeowner who fixed at 1.5% in 2021 and is remortgaging at 4.2% in 2025 will see their monthly payments increase substantially. On a £200,000 mortgage over 25 years:

• At 1.5%: monthly payment is approximately £800
• At 4.2%: monthly payment is approximately £1,080
• Increase: £280 per month or £3,360 per year

For households already stretched by higher energy bills, food costs, and other inflation-driven expenses, this is a significant additional burden. Some borrowers may struggle to afford the higher payments and could face financial distress or even repossession if they cannot remortgage or negotiate alternative arrangements with their lender.

Five-year fixes now cheaper than two-year

An unusual feature of the current market is that five-year fixed rates are now cheaper than two-year fixes, averaging 3.9% compared to 4.2%. This inversion reflects market expectations that the Bank of England will cut rates significantly over the next two years, making longer-term fixes more attractive to lenders.

For borrowers, this creates a dilemma. A five-year fix offers longer certainty and a lower rate, but locks you in for a longer period. If rates fall faster than expected, you could miss out on cheaper deals, though most five-year fixes allow overpayments and early repayment with penalties that decline over time.

A two-year fix offers flexibility, allowing you to remortgage again in 2027 when rates may be lower. However, you pay a higher rate in the meantime and take the risk that rates don't fall as expected.

Most mortgage brokers recommend five-year fixes for borrowers who value certainty and plan to stay in their property, and two-year fixes for those who may move or want to retain flexibility. The decision depends on personal circumstances, risk tolerance, and views on the economic outlook.

Will rates fall further?

The trajectory of mortgage rates in 2025 depends primarily on the Bank of England's decisions and market expectations.

The BoE has signalled that rate cuts are likely in 2025, with Governor Andrew Bailey stating in December 2024 that inflation is "under control" and the economy is "weak enough" to justify easing monetary policy. Markets expect the base rate to fall from 5.25% to around 4% by the end of 2025, with further cuts to 3% by 2026.

If these expectations are realised, mortgage rates could fall further, potentially reaching 3.5-4% for two-year fixes and 3-3.5% for five-year fixes by late 2025. This would provide additional relief to borrowers and support the housing market.

However, several risks could prevent or delay rate cuts:

• Inflation persistence: If inflation remains above the BoE's 2% target due to wage growth, energy prices, or other factors, the BoE may hold rates higher for longer.
• Economic resilience: If the economy proves stronger than expected, the BoE may be less inclined to cut rates aggressively.
• Global factors: Rising oil prices, geopolitical tensions, or financial market volatility could push up lender funding costs independently of the base rate.
• Government borrowing: High levels of government debt and borrowing could push up bond yields, increasing lender funding costs and limiting how far mortgage rates can fall.

Most economists expect rates to fall, but the pace and extent are uncertain. Borrowers should plan for a range of scenarios rather than assuming rates will return to pandemic-era lows.

The impact on the housing market

Lower mortgage rates are likely to support the housing market by improving affordability and increasing buyer demand. However, the impact will be gradual rather than dramatic.

House prices fell 3.2% in 2024, and most forecasters expect modest further declines or stagnation in 2025. Lower mortgage rates will help stabilise prices by making homes more affordable, but they are unlikely to trigger a new boom given the weak economic backdrop, high levels of household debt, and stretched affordability.

Transaction volumes, which fell 15% in 2024, may recover modestly as lower rates bring some buyers back into the market. However, many potential buyers remain locked out by high house prices, large deposit requirements, and economic uncertainty.

For sellers, lower rates are a mixed blessing. They may increase buyer demand, but they also reduce the urgency to sell, as homeowners with low fixed rates are less inclined to move and remortgage at higher rates. This "mortgage prisoner" effect has reduced the supply of homes for sale, contributing to market stagnation.

Regional variation

The impact of falling mortgage rates varies by region. In London and the South East, where house prices are highest and affordability is most stretched, lower rates provide meaningful relief but do not fundamentally change the calculus for first-time buyers. A 1% fall in mortgage rates on a £400,000 London property saves around £200 per month, but the deposit requirement of £40,000 (at 10%) remains a formidable barrier.

In northern regions and the Midlands, where house prices are lower and affordability is less stretched, lower rates have a more direct impact on buyer demand. A 1% fall in rates on a £200,000 property in Manchester or Birmingham saves around £100 per month and can make the difference between qualifying for a mortgage and being rejected.

Scotland, Wales, and Northern Ireland have also seen more modest house price growth and better affordability, meaning lower mortgage rates are more likely to stimulate demand and support price stability.

What borrowers should do

For homebuyers, the current environment offers better affordability than 2023 but remains challenging by historical standards. If you are in a position to buy, current rates of 4.2% for two years or 3.9% for five years are significantly better than the 6%+ rates available in late 2023, and there is no guarantee rates will fall much further in the near term.

For remortgagers, the key is to act early. Most lenders allow you to apply for a new mortgage up to six months before your current deal ends, and you can lock in a rate for up to six months. This protects you against the risk of rates rising while allowing you to switch to a better deal if rates fall before completion.

If you are struggling to afford higher payments, speak to your lender as soon as possible. Options may include extending your mortgage term to reduce monthly payments, switching to interest-only temporarily, or arranging a payment holiday. Lenders are required to offer support to borrowers in financial difficulty, and early engagement is key to avoiding arrears or repossession.

For those with flexibility, consider overpaying your mortgage while rates are fixed, as this reduces the balance and the impact of future rate rises. Most fixed-rate mortgages allow overpayments of up to 10% per year without penalty.

The bottom line

The fall in mortgage rates from 6.1% in October 2023 to 4.2% in January 2025 is a significant relief for homebuyers and remortgagers, saving hundreds of pounds per month and improving affordability. However, rates remain well above pandemic-era lows, and many homeowners remortgaging in 2025 will still face substantial payment increases.

The outlook for further rate falls depends on the Bank of England's decisions, inflation trends, and economic conditions. While markets expect rates to fall to 3.5-4% by late 2025, risks remain, and borrowers should plan for a range of scenarios.

For now, the worst of the mortgage rate crisis appears to be over, but the return to the ultra-low rates of 2020-2021 is unlikely. The new normal is probably mortgage rates in the 4-5% range—better than the peaks of 2023, but still a significant adjustment for a generation of borrowers accustomed to cheap money.