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Mortgage basics

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Written by:
06/06/2012
The basics of all things mortgages.

Variable rate mortgages

With a variable rate mortgage, the interest rate you pay can vary, moving up and down over time.

Every mortgage lender has a standard variable rate (SVR) that is loosely based on the Bank Rate; the benchmark interest rate set by the Bank of England.

Each lender sets its own SVR, usually a few percentage points above the Bank Rate. So where the Bank Rate is 0.5%, a lender’s SVR may be 3.0%, 4.0% – or higher in some cases.

Pros and cons of variable rate mortgages

A lender’s SVR is usually not the most competitive interest rate it has to offer. But these days the most competitive rates tend only to be available to borrowers with a very large deposit or a lot of equity in their property. Therefore the SVR can be an attractive rate for borrowers who do not have a large deposit or lots of equity.

Cash-back mortgages

Some offer cash-back mortgages, where you pay the SVR and are handed a cash lump sum on completion of the mortgage. Cash-back mortgages can be useful for those people who need cash upfront, but are rarely competitive over the longer term.

Discounted variable rate mortgages

Some mortgage lenders offer discounts off their SVR, which can be attractive.

A discounted variable rate mortgage works in a similar way to a tracker mortgage, but with a tracker the rate you pay is linked directly to the Bank Rate, rather than the lender’s chosen standard variable rate.

Get off the SVR

Whenever you take out a mortgage, it is important that you get the best deal possible, whether that is a discounted variable rate mortgage, fixed, capped or tracker deal. When you get to the end of a mortgage deal, you should see whether you can transfer to another deal. If you do not, you will automatically be transferred to the lender’s SVR. If you do not have a large amount of equity in your property, this may turn out to be the best rate available to you.

Your lender will inform you three months before you come to the end of your deal, giving you plenty of time to shop around for another. This is known as remortgaging.

Fixed-rate mortgages

Fixed-rate mortgages are fairly popular in the UK. As the name suggests, they allow you to fix the rate of interest you will pay on your mortgage for an agreed period. Most UK mortgage lenders offer a range of fixed-rate mortgages. The most popular are two-year, three-year and five-year deals, but it is sometimes possible to get a fixed-rate mortgage for anything from six months to 25 years.

As a rule, the longer you fix your rate for, the higher the interest rate you can expect to pay.

Pros of fixed-rate mortgages 1. They protect you against rising interest rates 2. Regardless of what happens in the economy and how the Base Rate moves, the interest rate you are charged is guaranteed to remain the same for the duration of your initial deal period 3. They give you peace of mind, as you know exactly how much will be coming out of your bank account every month with a fixed-rate mortgage. This in turn can help you with your budgeting.

Cons of fixed-rate mortgages 1. If interest rates fall during your fixed rate period, you will not benefit and may feel you are paying over the odds for your mortgage 2. Fixed-rate mortgages come with a fee. Fees have gone up rapidly in recent years. Don’t be surprised to be charged between £500 and £1,000 to fix the rate of your mortgage.

Capped rate mortgages

A capped rate mortgage is very similar to a fixed rate mortgage, in that there is a maximum interest rate set for a given period of time, and the rate you pay is guaranteed not to go above that rate for the agreed period.

However, with a capped rate mortgage, should the Bank Rate fall during that period the rate you pay for your mortgage will ‘track’ the interest rate downwards, reducing your mortgage repayments.

Pros and cons of capped rate mortgages

Capped rate mortgages protect you from rises in interest rates, while allowing you to benefit from any falls in rates. So they offer a win-win situation.

Like a fixed rate, a capped rate mortgage will come with a fee.

The main drawback is that capped rates are few and far between; not many lenders offer them, and when they do they are not available for long. Tracker mortgages

This type of product follows the Bank of England Base Rate or the lender’s Standard variable rate (SVR’s), plus or minus a certain percentage. For example, if your two-year tracker has a rate of Base Rate (BBR) plus 0.5%, if the Base Rate is 1.5%, your product rate will be 2.0%.

However, if the Base Rate drops to 1.0%, your rate will also fall to 1.5%. If your mortgage tracks your lender’s SVR it may not necessarily change in line with the Base Rate, however a Base Rate tracker is guaranteed to. It is also possible to get mortgages that track other rates, such as LIBOR (London Interbank Offered Rate; the rate at which banks lend to each other), but these products are nowhere near as common.

Lifetime tracker mortgages

Some mortgage lenders offer lifetime tracker mortgages, which will track the Bank Rate for the entire life of your mortgage by a guaranteed maximum percentage.

So they may promise never to charge you more than 1% above Bank Rate, for example. Again, lifetime tracker mortgages tend to come with relatively small fees, and with no ERCs attached.

Pros and cons of tracker mortgages

Tracker mortgages are straightforward and transparent, and some people like them because they the mortgage lender cannot influence the rate once its margin is set.

The rate you pay fluctuates directly in line with the Bank Rate set by the Bank of England, rather than being attached to the lender’s own Standard Variable Rate, which it can alter whenever it chooses for commercial purposes.

Tracker mortgages can be simple products for lenders to design, so they tend to come with lower fees than fixed, capped or discounted rates.

Discount mortgages

We all love a good discount – there is a certain satisfaction to be had from knowing you have gotten something cheaper than it should be. But did you know that when it comes to mortgages, it is sometimes possible to get a discount off your rate of interest?

Discount mortgages offer a percentage off a lender’s standard variable rate (SVR) for a set period of normally two to three years (although the time period can be longer depending on the deal). For example, if a lender’s SVR is 4.5% and the discount is 1.5%, you will pay a rate of 3% on your mortgage. With a stepped discount mortgage, your discount changes at one or more set points during the deal period, so you could have a discount of 2% below the SVR in your first year, and a 1% discount in your second year, for example.

Standard variable rate mortgages (SVRs)

After the discounted period, unless you switch onto another deal, your rate will revert to your lender’s SVR. In the past, borrowers were generally advised not to hang around on their lender’s full SVR for too long, as it used normally to be a couple of percentage points higher than the more competitive initial deal rates available and, as a result, made the repayments a lot more expensive. However, in the current market, unless you have a large deposit or a lot of equity in your property, the most competitive mortgage rates are unlikely to be available to you. Anyone without much equity in their property might be best simply sitting on the lender’s SVR, given that they are relatively low at present.

A mortgage lender can increase or decrease its SVR whenever it wants, so during the discounted period of a mortgage your payments are still liable to fluctuate. You should also bear in mind that if there is a cut in the Base Rate, some lenders may pass them onto the SVR, but it is by no means guaranteed.

So, while your payments may rise in line with the Base Rate, discount mortgages offer borrowers the possibility of benefiting from falling interest rates while also offering the certainty of a cheaper rate than your lender’s SVR, for a set period of time.

The discount tracker mortgage

Discount tracker mortgages work in much the same way as discount SVR mortgages, the only difference being that the discount applies to the Bank Base Rate rather than the lender’s own SVR. Before Bank Base Rate was slashed to its current historic low, many lenders offered a discount off their lifetime tracker mortgages for the first couple of years or more. For example, if the Base Rate was 1.25% and your mortgage was set to track it at -0.01% for two years, a change in the Base Rate to 1.00% would have made the rate on your mortgage 0.99%. Alternatively, if the Base Rate rose from 1.25% to 1.5%, your rate would have increased to 1.49%. However, because Bank Base Rate is currently so low, very few lenders are offering discounted trackers.

The stepped discount mortgage

This type of product works in a similar way to a discount mortgage (see above), except the percentage discount changes at several points during the deal period. For example, you could have a two-year mortgage product that carries a discount of 2% off the lenders’ SVR in the first and 1% in the second year, before reverting to the lenders’ SVR at the end of the deal period.

Who should take out a discount mortgage?

Discount mortgages are often popular with people looking to remortgage. People coming off an existing deal will have a bit more experience in the market, and are likely to be in search of a good short-term deal. first-time buyers are, generally speaking, more likely to go for a fixed rate mortgage, as this kind of deal allows you to fix your mortgage repayments at a set level for a certain period of time.

As the interest rate on a discount mortgage is liable to fluctuate, however, borrowers who are looking to stick to a set budget each month may not be entirely suited to this kind of mortgage.

Predicting what will happen to the Base Rate is far from easy – in fact, it’s impossible. Cashing in on decreases in this rate, or your lender’s SVR, is certainly something to consider, but remember that rates can go up as well as down.

Flexible and offset mortgages

A truly flexible mortgage allows you to do the following:

Overpay

Underpay

Take payment holidays

Borrow back overpayments

Not apply any Early Repayment Charges

Calculate your Interest daily

The best thing you can do with a flexible mortgage is make overpayments.

This will allow you to pay off your mortgage early and potentially save many thousands of pounds in interest payments.With interest rates currently at a record low, many thousands of flexible mortgage borrowers have taken the opportunity to overpay and reduce their mortgage debt in recent years.

But the beauty of a flexible mortgage is that it then allows you to borrow back those overpayments if you need to, or you could decide to stop paying your mortgage for a month or two, maybe when expenditure is at a peak.

To be really flexible, a mortgage should allow you to leave it without paying an early repayment charge (ERC), but as many flexible mortgages these days come as fixed rates or with discounts, this is not always the case.

Finally, it is important that interest is calculated daily, so that any overpayment is taken off your mortgage as soon as you pay it.

While some lenders advertise fully flexible mortgages, thousands of other mortgage deals come with flexible features these days; the most common being the facility to overpay. Some will only allow you to overpay a maximum figure per month (eg £500), while some will let you pay off a maximum percentage of the mortgage amount per year (eg 10%).

Pros and cons of flexible mortgages

Flexible mortgages put you in charge of your finances, and offer the potential to save a huge amount of money if used properly.

They can be ideal for anyone with a fluctuating income, such as the self-employed, or people who work on commission.

Offset mortgages

An offset mortgage is the ultimate flexible mortgage. It takes a bit of understanding, but those borrowers who have converted to offset mortgages are big fans, as they can offer the most efficient and easy way of managing your money.

An offset mortgage pulls all of your finances into a single account. So it runs your current account, mortgage, savings and personal loan accounts together. On a daily basis, it adds up all of your assets and your savings, plus the money in your current account, and offsets them against your debts (mortgage and loans).

Say you have a mortgage of £100,000 and savings of £10,000, and you typically have a balance of £1,500 in your current account when you get paid.

Rather than paying, say, 5% interest on your mortgage, earning 1% on your savings and 0% on your current account, the offset calculates that you have debts of £88,500, and simply charges you interest on that.

Pros and cons of offset mortgages

Because rates for mortgages and loans are higher than savings and current account rates, it makes sense to NOT PAY the interest on the £11,500, rather than to earn the interest on it. And, because you are effectively regarded as having nothing in your savings account, you don’t pay tax on it.

Offset mortgages keep your money in virtual ‘pots’, so you can still see how much you effectively have in your separate accounts, but it gets your money working as hard as possible for you.

The main drawback is that offset mortgages can be quite difficult to get your head around initially.

Interest-only mortgages vs repayment mortgages

Before you go looking for a mortgage or remortgage deal, you need to decide how you are going to pay off your mortgage. Should you go for the safe repayment-type model, or opt for an interest-only method of repayment?

Interest-only mortgages

With an interest-only mortgage, the payment you make to the mortgage lender each month comprises just the interest you owe them for that month. So you are not paying off any of the capital you owe.

When you take out an interest-only mortgage, you are supposed to also make a monthly payment into an Individual Savings Account, endowment or other investment. The hope is that the investment will then generate sufficient returns to pay off the capital sum you still owe at the end of the mortgage term.

However, there is no guarantee of this, so any interest-only mortgage carries an element of risk.

In the boom years of the property market, increasing numbers of first-time buyers took out interest-only mortgages, and have just paid the interest, not paying any money into an investment. With high house prices, this was the only way some people have managed to afford to buy property. When taking out an interest-only mortgage and just paying the interest, borrowers relied on their property going up in value, being able to sell it a few years down the line for a profit, and then buying a property with a repayment mortgage.

Mortgage risks

But this approach was fraught with risk. Firstly, house prices are not guaranteed to go up – in recent years they have fallen in most parts of the UK. Secondly, many people sort out their mortgage and then forget about it. If you never get around to converting your interest-only mortgage to a repayment-type, and you have no investment fund building up, there is a very real risk that you may get to the end of your 25 year mortgage term still owing all of the capital initially borrowed and with no way of repaying it.

To avoid this happening going forward, most mortgage lenders now make it very difficult for borrowers to take out interest-only mortgages. They may demand a very big deposit and/or ask for tangible proof that you have an investment plan in place to pay off the mortgage at the end of the term. And some have stopped accepting plans such as a future inheritance as backing for taking out an interest-only mortgage.

Repayment mortgages

With a repayment-type mortgage, the monthly repayment you make to the lender each month consists of the interest you owe plus a little bit of the capital you owe. If you keep up all the repayments on your mortgage, you are guaranteed to have paid off the mortgage at the end of the term. Repayment-type mortgages are therefore the safest option, and are by far the most popular mortgage type in the UK.

Buy-to-let investors

Buy-to-let investors are the only borrowers who are advised to take out interest-only mortgages with no investment vehicle. That is because the rent covers your interest payments, and the long term plan is generally to sell the property in the future, and pay off the capital at that point. Mortgage guides Mortgage calculators

Find out how much you could borrow, calculate your monthly mortgage repayments and work out your fees, using our suite of easy-to-use mortgage calculators. Choose from the following:

• How much can I borrow?

• How much will it cost?

• Buy to let borrowing calculator?

• Buy to let rent calculator?

• Effect of overpaying

Although these mortgage calculators will give you a rough idea of the likely costs of any deal you are considering, it may be sensible to consult an adviser for more specific information.

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