A repayment mortgage versus an interest only mortgage is merely the first decision you have to make. What sort of repayment or interest only deal do you want? While interest only mortgages aren’t bad, they are risky. Risk is an important concept in finance; it’s about taking a chance. The historic problem with interest only mortgages has been that most people who took them out did so without realising there was a risk. That is bad. The point is the investment you use to repay your interest only mortgage may soar, in which case it pays off your house plus profit on top, or it may plummet in which case you need make up the shortfall at the end of the term. It is possible for a detailed rational gamble on an interest only mortgage to pay off. Yet that gamble is beyond the scope of this guide. The reason most people are, and should be, cautioned against these mortgages, is planning, understanding and managing that gamble is complicated, and rarely something to risk your house on.
Standard Variable Rate (SVR)
This is the simplest and most straightforward mortgage product you can get.
The SVR is linked to – but is not the same as – the Bank of England interest rate, known as “base rate”. SVRs’ are generally a couple of percentage points or so higher than base rate. As the Bank of England shifts its rate up and down so lenders tend to move their SVRs. But beware, there’s nothing forcing lenders to do this, so even if the Bank of England cuts rates by 0.25%, your lender might only reduce its rate by say 0.15%. Funnily enough, when the Bank puts its rates up, lenders do tend to pass on the whole increase immediately and sometimes more on top.
Simple, and when base rate is low, government pressure can see these fall sharply.
No guarantee you’ll get the full benefit if rates fall.
Alongside their SVRs’, banks and building societies offer a whole range of other mortgages. Most are special offers which last for a set period of time, after which lenders shunt customers back to the SVR where they hope you’ll stay. Many of the features below can be and are used in combination.
Unlike the SVR, a tracker usually follows the base rate absolutely. So if rates go up by 1%, your mortgage payment goes up by 1%. But if it falls by the same amount then your mortgage will drop by the full 1% as well. However, some products also have what’s called a “collar” which is a minimum level below which the rate will not drop. This was first enforced towards the end of 2008. Some had a 2.75% or 3% collar which meant once base rate fell below these levels their trackers stopped falling in price. Lenders can also offer “lifetime trackers” which guarantee to follow the base rate for the length of your mortgage.
You get the full benefit of all Bank of England rate falls – subject to any “collar”.
You get the full benefit of all Bank of England rate increases.
With a discount mortgage you get a rate which is a set percentage below the lender’s SVR (or another specified rate). So it’s the interrelation between the two which determines whether it’s an attractive proposition, as the following example shows:
This has an initial discount rate of 1.99% for two years, but the rate rises to 4.95% after the initial deal ends.
Saffron Building Society
This offers an initial discount of 1.49%, again for two years, but this time the rate rises to SVR of 5.39%. So the rate you pay at the end of the deal is a huge 5.39%.
So it’s important to make sure you know both the size of the discount and the level of the SVR. Some deals discount from a tracker rate rather than the SVR. For example, a lender could have a tracker where the rate is set at base rate + 0.75% and then offer a two year 0.50% discount on top. That would mean you would end up paying base rate + 0.25% during that time.
Even if rates rise, you’ll be paying less than the SVR. If rates fall you get the full benefit.
Discounts tend to last for a relatively short period – typically 2 or 3 years. And your payments will always increase if the Bank of England puts up interest rates.
This is pretty simple really. The rate is fixed at the outset and doesn’t move for the length of the deal. Fixed-rate mortgages have become very popular in the last few years. Two thirds of all mortgages taken out in 2006 were fixed, the vast majority lasting for 2 or 3 years.
Lenders will let you fix for 10, 15 or even 25 years, something the government is trying to encourage. But longer term fixed rate deals have never really taken off, largely because, despite the fact that many of these deals will let you take the mortgage with you if you move, people, rightly, are wary of locking in for such a long period of time. Early repayment charges often apply for the first 5 or 10 years of such deals. When getting a new fixed rate, the interest it’s set at is not always closely aligned to the Bank of England’s base rate. Instead lenders price their deals according to the cost of money they go out and buy on the wholesale money markets. This is why you often have to pay to “buy” a fixed rate this is because the lender has to secure a matching pot of money to fund the loan. Although you are insulated from the effects of any rate rises during the period of the loan, if rates have gone up, you may face a steep increase at the end of the deal, so called “rate shock”.
Certainty: Your payments will not go up if the base rate increases. Most long term fixed rate deals are portable.
You will not benefit from any falls in the base rate. You may have to pay a fee to book your rate. Long term fixed rate deals tend to have extensive early repayment charges. There is also the risk of rate shock at the end of your deal. There is no right answer here. It depends on your circumstances and your priorities. A fixed rate is like an insurance policy against interest rates going up. That protection costs money, so all things being equal, unless there are exceptional circumstances, a 3 year fix is likely to have a higher initial rate than a 3 year discount. However the rate of the discount deal may go up or down.
Do you need certainty?
Choosing a rate isn’t purely about which is the very cheapest. Deciding whether to fix is a question of weighing up how important that surety is for you. I tend to think of this as a “how much can I really afford?” question. Someone who can only just afford their mortgage repayments should not be gambling with interest rates and, therefore, will benefit much more from a fixed rate as it means they’ll never be pushed over the brink by an increase. Those with lots of spare cash over and above the mortgage may choose to head for a discount and take the gamble that it will work out cheaper in the long run.
Don’t look back in regret
If you do decide to go for a fixed rate on the basis of security and afterwards look back with hindsight and realise a discount rate would’ve been cheaper, this doesn‟t mean it was the wrong decision. If you needed surety, remember you got it.
There are also a couple of other special offer deals to consider:
With a capped mortgage the rate you pay moves in line with base rate but there is an upper ceiling or “cap” above which it will not go. Some deals also have a lower limit or “collar” below which the rate will not fall, whatever happens to rates. As you might expect, these mortgages prove popular when people are frightened that rates might soar. They tend to be more expensive than fixes. There are only a handful of capped deals on the market, reflecting the falling popularity which has seen them account for only 1% or 2% of new mortgages in recent years.
You benefit from interest rate falls and have some protection against rises.
There is a limited product choice. The “cap” is often set quite high and the starting rate can be expensive.
With a cash back mortgage, your lender gives you, some cash back. Hence the name, you might get a lump sum back of say 5% or even 10% of the amount of money you borrow. Whilst this money is bound to come in handy, as ever, what a lender gives with one hand it takes back with the other. Generally cash back mortgages charge higher rates than standard loans and charge you penalties if you want to repay or switch your loan within a set period, usually 5 years. Basically your lender takes its cash back.
You get a nice cash lump sum.
You pay for it in other ways. Watch out for higher interest rates and hefty early repayment charges.
New Style Mortgages
All the mortgages we’ve looked at so far are variations on a pretty simple theme. You borrow a set amount of money, you pay back a certain amount every month, and your debt is the amount you borrowed minus the repayments you’ve made. So far plain sailing, but the last few years have seen the growth of a completely different type of mortgage. It lets you use your savings and/or the money to offset your debts, reducing the total amount of money you owe. As with basic Standard deals, these can be structured as variable, fixed or discounted deals.
Current Account Mortgage (CAM)
As the name suggests it combines your mortgage and current account to give you one balance. So if you have £2,000 in your current account and a mortgage of £90,000, then you are effectively £88,000 overdrawn. Your debt is therefore smallest just after your salary is paid in and creeps up as you pay bills and so on throughout the month. You must make a standard payment every month which is designed to clear your mortgage over whatever term you choose. The extra money floating around in your account acts like an overpayment which should mean you actually pay off the mortgage much more quickly. Any extra cash savings can be added to reduce the balance further. Or you can transfer other debts like credit cards or personal loans to the account to take advantage of the lower interest rate.
If used correctly, someone who spends less than they earn each month is effectively overpaying their mortgage every month and so should clear it more quickly, potentially saving thousands of pounds. However this is not unique to CAMs.
You have to be very much organised with your money. Psychologically do you want to be permanently overdrawn? Plus the interest rates charged on CAMs are higher than those on normal deals. To work well you need to have a reasonable amount of money coming into, and floating around, your current account.
This time, instead of having one big pool of money, an offset keeps your mortgage, savings and current accounts in separate pots. But, as above, your savings are used to reduce or “offset” your mortgage. So, if you have a mortgage of £150,000 and savings of £15,000, then you only pay interest on the £135,000 difference. As with the CAM you make your standard payment every month but your savings act as an overpayment, wiping out more of the capital every month, helping you clear the mortgage early. It’s also a good deal in terms of tax. This is because the interest rate you would get if you put the £15,000 in a savings account is usually lower than the rate you pay on your mortgage. And you’d have to pay tax on any interest you got. It’s far better to pay less interest on your loan than earn interest on your savings. So these accounts can be particularly good value for higher rate taxpayers. They are also popular with self employed people who can use the cash they build up over the year towards their tax bill to reduce their mortgage.
You effectively overpay your mortgage every month, letting you clear it more quickly, potentially saving you thousands of pounds. Your savings and debts are kept separate so it’s easier to keep track of your money. Also tax efficient, especially for higher rate taxpayers.
As with CAMs, the interest rate is higher than on more straightforward mortgages. So you do need to have reasonably substantial savings typically 40% of your mortgage’s value to make the sums add up. If you need to spend your savings for any reason, then your mortgage will become more expensive. Steady there. OK offset and current account mortgages sound great. Yet there’s a lot of hype mixed in with these flexible friends.
The decision boils down to two questions. Will you use all the extra features? And is the higher interest rate you’ll pay off set by the benefit?
Is it just the ability to overpay you want?
The one facility most people use their flexible feature for is overpaying. This is the ability to pay off your mortgage more quickly in order to reduce the total amount of interest you will pay. Yet these days most bog standard mortgages will also allow you to overpay and if that’s all you’re looking for, just get a normal cheap mortgage with an overpayment facility.
Don’t believe the hype surrounding marketing
My greatest wrath is saved for some current account mortgage providers. They provide illustrations which show how many tens of thousands “paying your salary into your mortgage” will save you. Yet this is a myth. Check the numbers behind those illustrations and you’ll see it always includes a fact similar to “you spend all bar £100 a month” in other words you’re overpaying by £100 a month. While of course this overpayment is beneficial, it’s not unique to the current account mortgage. In fact, the pure benefit of actually paying your salary into your mortgage account each month (if you take out the overpayment) is only equivalent to a 0.1% discount in interest rate and these type of mortgages are a lot more expensive than that in the first place. Unless there’s a very special cheap rate these should most often be avoided. Even once you’ve chosen the type of mortgage you want, there are some other things to check. Is the mortgage available for re-mortgages? Seems obvious but not all deals are. Will the lender lend me the money I want based on the value of the house?
Most lenders will only let you borrow a certain proportion of the property‟s value. This is the Loan to Value ratio or LTV. A typical LTV is 75%. You often only get the best rates if you can get down to 60% or under. This might not sound a big deal but it has had a massive impact on many. House price falls have meant most people will have seen their LTV ratio rocket. Say you bought a £200,000 home a year ago and took out a £150,000 mortgage: that’s a 75% LTV. But assuming 20% annual house price falls, meaning your home is now worth £160,000, you’d have a 93% LTV with a £150,000 mortgage. Do I meet the lender‟s borrowing criteria? Check whether you meet other requirements e.g. minimum salary or employment status. Beware if your circumstances have changed since you took out your current mortgage, you may not be able to borrow as easily or as much as before. Does the lender charge daily interest? This makes a huge difference to the amount of money you pay back. With daily interest, the amount you owe is recalculated every time you pay money off. And when you owe less, you pay less interest. With annual interest you don’t get the benefit of 12 months payments until the end of the period.