A Beginner's Guide To The Credit Crunch

If you had mentioned a credit crunch a year ago, most of the population would have had no idea what you were talking about, but today it’s a phrase that most people have heard, even if they are still a little unsure of what it is.

To help borrowers understand what it is and how it could affect them, this beginner's guide looks at what happened and why, who has been affected and what you can do to minimise the impact.

What Is It?

A credit crunch is when banks slow down the flow of money they are prepared to lend to other banks and financial institutions.

The reason behind the current slowdown is that banks are increasingly wary of who they lend to as they are unsure who has been caught up in the US sub-prime mortgage lending crisis, or to what degree.  In the US, many borrowers have defaulted on their mortgage as their cheap initial interest rates have come to an end and they find they have overstretched.

Why has this become a problem for the UK?

The reason this has crossed the Atlantic and become a problem here, is that many European banks have some exposure to these mortgages through various types of investments - the value of these assets has fallen dramatically. This has made banks reluctant to lend to each other as they are worried that they may not get their money back - instead they are keeping hold of their cash.  In other words it’s a crisis of confidence in bank solvency.

How Does This Affect Us?

Very simply, banks are finding that the cost of borrowing has increased as funds are scarcer, and in an effort to protect their profit margins, they are passing on the increased cost to the consumer through higher mortgage rates.

In addition, mortgage lenders have found that this increase in cost has not always slowed mortgage demand and some lenders have struggled to maintain service standards. Many of the market-leading rates are being withdrawn with little or no notice, (sometimes only days after the scheme first became available) in an effort to stem the tide of new applications.

Part two of this guide will cover who has been affected and how, and part three will look at what you can do to minimise the impact.

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