Very few of us can afford to buy a property outright using either spare cash or cash from another property sale. As such the purchase of a property is typically financed through a mortgage, but the mortgage market can be a maze of different options. Do you know your standard variable rate mortgage from your fixed rate, from your tracker or even from your discounted rate? What about offset mortgages or interest only mortgages? It is all a little confusing, isn’t it? In this article we will try and shed some light on the different mortgage types:
Types of mortgage
At their most basic there are two different types of mortgage: Variable rate and fixed rate. Variable rates can be further subdivided into three categories: Standard, tracker and discounted. The final piece of the puzzle is that both fixed rate and variable rate mortgages can be offset and mortgages can be interest only. We will cover each one of these in detail starting with Fixed rate mortgages.
Fixed rate mortgage
A fixed rate mortgage is exactly that, a mortgage with a fixed rate of interest for a specific period of time. The advantage here is that, for that specific period of time, be it 2 years, 5 years or even 10 years, you know exactly what your mortgage payments will be every single month and these will not change no matter what the Bank of England interest rates are.
How do fixed rate mortgages work?
Mortgage lenders will have a varied offering of fixed rate mortgages but the most common are 2 year and 5 year terms but these can be as long as 10 years or even 15 years.
What typically tends to happen is that the interest rates for the longer terms are slightly higher and this is how the mortgage lender ensures that they can cover swings in interest rates. You will also see that lenders offer slightly different interest rates on the same length fixed mortgage deal, so they might have a two year fixed deal at, say 2.11% and another at 1.99%. Clearly the latter has lower monthly mortgage repayments, but it might come with a product fee which could be around £999. You can normally tack the mortgage fee onto the mortgage itself but then you have essentially increased your loan value and the amount of equity you need to pay interest on. It could be that, over the period of the loan or even just the fixed term, you actually end up paying more with the lower interest rate due to the mortgage fee. Talk to your mortgage advisor to get you the full cost breakdown of what you will pay over the fixed term rather than just looking at the headline interest rate.
You will also find that there are different rates based on how much you want to borrow versus the value of your property (this is called the loan to value (LTV) percentage). The lower your LTV the lower the interest rate typically. This is because the risk of going into negative equity is less and so the risk of loss to the lender is also less.
Advantages of a fixed rate mortgage
There are clear advantages of a fixed rate mortgage such as the ability to budget accurately. You will know exactly how much you will be paying each month for every month of the fixed term. Having a fixed interest rate also protects you against increases in interest rates and increased monthly payments.
Disadvantages of fixed rate mortgages
Locking in an interest rate, especially if over a longer period like 5 or 10 years does protect against increases in interest rates, but if the interest rate goes down, then you are stuck paying a higher interest rate than the market rates. Fixed rates also tend to have slightly higher interest rates than tracker or discounted tracker mortgages. Finally, it can be costly to come out of a fixed rate mortgage deal before the end of the fixed term.
Leaving a fixed rate mortgage early
Clearly a lender wants you to stay in the fixed term for the whole time of the term, this is how they have calculated their own financials. If you want to leave early, either to go to another lender who might have lower rates or to go onto a lower rate with your existing lender, or simply to just pay off the mortgage, your lender will lose money. As such most fixed rate mortgages come with an early redemption charge. This charge can be one to two month’s interest but can be more. The earlier in the deal that you want to leave, potentially, the higher the charge. This will be clearly highlighted in your mortgage agreement, but you should make yourself aware of the charges as they can be considerable.
What happens when my fixed rate mortgage ends?
You have three main options here:
- As you come to the end of your fixed term, talk to your lender and see if you can move to another mortgage product with a good rate of interest. This might typically be another fixed rate mortgage.
- Look around on the open market for other mortgage deals and, at the end of the term, switch to a different product with a different lender
- If you do nothing, then you will automatically revert to your current lender’s standard variable rate (SVR). During times where interest rates are very low, this could actually be a good thing to do, especially if rates have dropped during your fixed term. This situation is quite rare though, so make sure you do your research well in advance of your fixed term ending.
Variable rate mortgages
As the name suggests, the interest rate on these mortgages can go up or down depending on what the Bank of England base rate is doing. There are three main types of variable rate mortgage: Standard variable rate, tracker mortgages and discounted mortgages and each has its pros and cons.
Standard variable rate mortgages
All mortgage lenders have their own standard variable rate mortgages and typically the only time you end up on one is when you come to the end of a fixed term mortgage or the end of your discounted or tracker mortgage. There are advantages and disadvantages of standard variable rate mortgages:
Advantages of standard variable rate mortgages
In times when interest rates are falling, your interest rate should fall too, reducing your monthly repayments. You will need to keep an eye on this as a lender is not obliged to pass on interest rate cuts to you. You can also, typically overpay or completely pay off your mortgage with no fees such as the early redemption charge and most SVR mortgages have no arrangement fees.
Disadvantages of standard variable rate mortgages
Most standard variable rate mortgages aren’t that competitive when compared to the fixed rate mortgages or the other variable rate making them more expensive on a month-to-month basis. If interest rates increase, then your mortgage payments will also increase accordingly, which could make the mortgage unaffordable. It is rare for a lender to not pass on base rate increases, but it is at the discretion of the lender so passing on increases is not guaranteed. The variable nature of the product makes it harder to budget your finances month to month. The rate is set according to the policies of your lender and have no relation to any other external influence like the Bank of England Base rate and can be changed at any time.
These mortgages are also variable but they are set up to track the bank of England Base rate or other financial interest rates like the London Interbank Offered Rate (LIBOR).
How do tracker mortgages work?
Basically, the mortgage will be described as “base rate + x%”. This x% is set by your lender and can be 1%, 2% or whatever they want. This then means that your mortgage interest rate will track at say 2% above the prevalent Bank of England Base rate. If, for example, the base rate is 0.5% then your interest rate will be 2.5% (0.5% + 2%). The rate that you pay, will then only change when the bank of England changes its base rate. There are, however, advantages and disadvantages of tracker mortgages.
Advantages of tracker mortgages
Interest rates for tracker mortgages tend to be quite low and are quite often less than fixed rate mortgages. Your interest rate will drop if the bank of England base rate drops. This is guaranteed, unlike standard variable rate mortgages.
Disadvantages of tracker mortgages
If the Bank of England base rates increase, your mortgage payments will also instantly increase. Unlike SVR mortgages the tracker is linked directly to the base rate so any increase will guarantee an increase in interest rates. The variable nature of the product makes budgeting that bit harder as your payments can go up and down each month. If your deal has what is called a rate collar (essentially a minimum rate below which it will not drop) you will not always benefit from drops in base rates.
These are a variation on the theme of standard variable rate mortgages, where the lender offers a rate which is variable but discounted compared to their standard variable rates. In essence it is a standard variable discounted tracker rate. So, if the lender has a standard variable rate of say 4% and your mortgage is discounted by 2% you would pay 2% interest. If the lender’s SVR rises to 5% you would pay 3% and so on. So, what are the advantages and disadvantages?
Advantages of discounted mortgages
These mortgages have lower interest rates than normal SVR mortgages, making them more competitive and also more affordable. This is especially the case when interest rates are low. They can have rates as low as tracker or fixed term mortgages. Early redemption penalties are likely to be lower than for fixed rate mortgages. Arrangement fees for discounted mortgages are likely to be lower than fixed rate mortgages.
Disadvantages of discounted mortgages
As with all variable rates, budgeting is not easy as your payments can change regularly. This is compounded by the rate tracking your lender’s variable rate which can be changed at any time by your lender. As with normal tracker mortgages, there can often be a rate collar which limits how low the interest rate can drop, meaning that you might not benefit from all reductions in interest rates.
It pays to get advice
Hopefully this has clarified the various mortgage types on the market and given you some food for thought. It is advisable to talk to a mortgage expert and properly compare all the different deals for the mortgage types to work out what you will pay.
Now just to add a little more to the things to think about, we will quickly look at interest only and offset mortgages.
Interest only mortgages
These are becoming increasingly rare outside of the buy-to-let market but, as the name suggests, all you do on an interest only mortgage is pay off the interest rather than the value of the property and the interest. This can significantly reduce your monthly repayments. Giving you a comparison for a £200,000 mortgage being paid off over 25 years at 3%:
Interest only monthly repayments: £500
Repayment monthly repayments: £948
So, interest only mortgages are much cheaper but therein also lies the biggest concern. At no point do you actually pay off the original equity loan. At the end of the term, you still owe the entire amount, in the case above, this would be £200,000. For a repayment mortgage, at the end of the term you would owe nothing. For an interest only mortgage, you will need to show your lender that you will have the means to pay off the equity loan at the end of the term. You cannot always rely on simply selling the property because, if there is a market crash, your property might be worth less than the outstanding mortgage.
Offset mortgages are ones that are linked to your savings account, which has to be with the same lender. In essence the lender reduces the amount of the mortgage you pay interest on by the amount of savings you have. So, if you have a £150,000 mortgage and savings of £10,000 then you only pay interest on £140,000 and this reduces your monthly payments. In the long term this will save you significant sums of money and the more savings you have the larger the mortgage savings. What are the advantages and disadvantages?
Advantages of an offset mortgage
Lower monthly interest payments are one advantage but if you choose to pay the “normal” amount every month then you will pay off your mortgage earlier. Either way the savings can be substantial. Quite often the reduced interest on your mortgage will be more than the interest you would receive on your savings so it is a better use of your savings. You won’t pay tax on the benefits as you would on your savings account where you would pay tax on any interest paid.
Disadvantages of an offset mortgage
The interest rates for offset mortgages tend to be a little higher compared to “normal” mortgages and you won’t earn any interest on your savings, which, if you have considerable savings might mean you lose money by offsetting.
There are many different types of mortgages and each one has its own advantages and disadvantages depending on your personal circumstances. We hope that this guide has helped you, but we strongly advise that you obtain the assistance of an independent mortgage advisor whenever you are looking at your mortgage requirements.