Mortgage rates soared to their highest level in more than seven years last month following a sharp rise in the cost borrowing between British banks.

According to the Bank of England, the average rate for a tracker mortgage pegged to the base rate jumped from 6.12 per cent in September to 6.84 per cent in October. Figures are based on deals available to borrowers with a 25 per cent deposit.

Experts said the rapid increase in mortgage rates was down to a sharp rise in the cost of borrowing between banks in the wholesale money market following the collapse of Lehman Brothers, the US investment bank, in mid-September.

Three-month sterling Libor, which is the rate banks use to lend money to each other and is key for mortgage lending, rose to 6.29 per cent – the highest point for 10 months.

Since then wholesale borrowing costs have fallen significantly. This morning, three-month sterling Libor fell from 4.42 per cent to 4.37 per cent after the Bank of England last week cut the interest rate from 1.5 per cent to 3 per cent.

Last week, lenders pulled almost every tracker deal on the market after the dramatic reduction in the base rate. However, following the drop in Libor, deals are now beginning to reappear.

Abbey, the UK's second biggest lender, will tomorrow be the first to re-launch tracker deals pegged to the base rate.

The gap between the rate on offer and base rate will be up to 0.7 percentage points higher than previous deals. However, borrowers will still pay less than they did before the base rate was cut last Thursday.

Homeowners with a 25 per cent deposit will be offered a rate of 1.99 above base, or 4.99 per cent. The old deal was 1.29 above base.

Other lenders, including Halifax, the biggest mortgage lender, and Lloyds TSB, are expected to follow suit and launch new tracker deals in the coming days.

Christoph Rieger, rates strategist at Dresdner Kleinwort in Frankfurt, said: "It looks like the combination of lower rates, more liquidity and government schemes are helping to bring Libor rates down, but a more profound decline probably won’t come before the end of the year.”

Interbank lending rates are crucial for mortgage borrowers as they determine the cost of variable-rate deals.

Two-year swap rates, which are closely aligned with the price of fixed-rate mortgages have also fallen, dropping from 4.26 per cent to 3.87 per cent last week in the wake of the base rate cut.

The falling swap rate has already prompted lenders to launch a number of new fixed-rate products this week. Abbey and Lloyds TSB have unveiled cuts of up to 1 percentage points on new fixed-rate deals.

Ray Boulger, of John Charcol, the broker, said; "The big increase in the average rate last month might be alarming, but the whole market situation changed dramatically as a result of Lehman Brothers collapse. Money markets froze, banks didn't lend to other banks and rates were increased.

"The outlook now is very encouraging. Abbey and C&G deals are very competitive and there appears to be a growing appetite for lending, in part because the money markets are beginning to unfreeze. However there are still only a half-a-dozen lenders are still lending.

The Bank of England’s figures showed that while two-year fixed rate mortgages for new customers with a 25 per cent deposit fell by 0.16 percentage points to average 5.8 per cent during the month, the cost of other fixed rate deals increased.

Five-year fixed rate mortgages for borrowers with a 25 per cent deposit rose by 0.5 percentage points to 5.89 per cent, while 10 year deals jumped by 0.22 percentage points to 6.26 per cent.

The average standard variable rate (SVR) fell by only 0.01 percentage points to 6.94 per cent during October, although this may be because most lenders who did reduce their SVR following the base rate cut waited until November 1 to do so.

But only 54 out of the 96 lenders that have an SVR mortgage passed on October’s interest rate cut to new and existing customers, with many of these failing to pass on the full 0.5 per cent reduction.

So far a total of 19 mortgage lenders have said they will reduce rates following November’s base rate cut, with all but one passing on the full 1.5 per cent.

HSBC, Woolwich, owned by Barclays, and Alliance & Leicester are yet to pass on the base rate cut to borrowers on a variable rate.

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