Fixed vs Discount Mortgages

It’s mortgage crunch time; you’re ready to get a deal, but should you go for a fix, discount or a tracker? This is a full Q&A ‘fixed v discount’ guide to help you decide what’s right for you, plus if you’re locked into a high rate, there’s the quick ‘should I ditch my fix?’ calculator

• How do fixed rates work?
• Discounts and Trackers
• Picking Fixed vs Discount
• Should I ditch my fix?
• 'Should I ditch my fix?' Calculator
• What is a collar?
• How are fixed rates priced?
• What does mortgage APR mean?

Which path should you take?

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How do fixed rates work?

A. When you fix, the rate doesn't change for a set time. It's, well...er...fixed! So a fixed rate of 5% for two years means this IS what you’ll pay, irrelevant of any UK interest rate changes or owt else.

Think of a fixed rate like a sales offer; in return for signing up to the mortgage, the lender is agreeing to give you a short term special rate. This is why if you try to change mortgage during that period, you’ll almost always have to pay a large penalty, meaning most who get a fixed rate are effectively locked into it for the period.

Yet the big advantage of fixed deals is you know EXACTLY what you’ll pay, giving security and meaning you can budget around it.

The difference between a discount and a tracker?

A. Both discounts and trackers are types of variable rate mortgages, where the interest rate you pay can and usually will change over time. In fact the two terms aren’t exclusive, as there are such things as ‘discounted tracker’ rates. To explain it, lets go back to basics.

If you get a variable rate mortgage, the amount you pay is usually based on one of two underlying rates...

• Lenders' Standard Variable Rates (SVRs).

  Each lender sets its own SVR and while it tends to move up and down with the UK base rate, it doesn’t have to. In fact it can move willy-nilly based on the lenders' own competitive reasons. The most important thing to remember is...

  Lenders can do whatever they want with their SVRs. You have no guarantee on what’ll happen with it.

  Of course competitive pressures, and in recent times Government and press scrutiny, mean most of the time it moves in the same direction as UK rate changes, but not necessarily by the same amount.

• The Bank of England Base Rate (Trackers)

  Tracker mortgages mean the rate is guaranteed to move with UK base rates, which are set each month by the Monetary Policy Committee of the Bank of England.

  Yet it doesn’t mean your mortgage rate will be the same as the Bank of England rate, e.g. you could have a ‘Base Rate + 1%’ tracker; which means the underlying rate of the mortgage will always be one percent higher than current UK base rates.

Thus on the surface it seems like a tracker is always the best deal, as it’s guaranteed, yet the tracker could be set at a higher start rate than the SVR, and that sways the balance. Plus some trackers have a minimum rate level, which sets a certain amount below which your rate won’t go.

What's the discount off?

Think of a discount rate like a short term special offer, given to you by the mortgage lender in order to suck in your custom. The rate is much cheaper than normal, usually for two to five years, though you will often need to agree to pay a hefty penalty if you want to pay off the mortgage or switch to a new mortgage deal within that time.

As there are two underlying rates, there are two types of discount.

• Discount Mortgages.

  When discounts are usually talked about, it means a discount off the SVR. For instance, you may get a 2% discount off the SVR for the first three years.

• Discounted Trackers.

  Here you get a discount off the standard tracker rate, eg. a 2% discount off the tracker rate for the first three years. Yet in this case you need to be careful to understand EXACTLY what it means...

  Ray Treducer has spotted a mortgage offered with a 1.5% discount off the normal tracker rate for three years. He checks and finds it's a ‘Base Rate + 2%’ tracker.

  To find his mortgage rate, Ray has to subtract the discount from the normal tracker rate. That means he will be paying 0.5% more than UK base rates for the first three years of his mortgage.

It’s what you pay that counts.

It’s not the size of the discount that counts, but the underlying rate you pay. Don’t be drawn in by the discount size, examine the entire rate.

• Barstools Bank. This has a huge 2% discount for two years, but the underlying Standard Variable Rate is 5.5%. In other words the rate you actually pay is 3.5%.

• Lendright Bank. This only offers a 1% discount, again for two years, this time from an SVR of 4%. So even though the discount is smaller, the actual rate you pay is lower, at 3%.

How do I pick fixed or discount?

A. Traditionally, fixed rates are set slightly higher than discount rates; though that varies due to the overall economic climate. The most important thing to remember is...

With a fixed rate you have the surety of knowing exactly what your mortgage repayments will be for that time.

In my view, this is the crucial factor; deciding whether to fix is a question of weighing up how important that surety is for you.

It’s a ‘how close to the edge are you?’ question

There are no hard and fast rules but one way to think of this is, the nearer you are to the financial edge, the more you should hedge towards getting a fixed rate.

Those who can only just afford their mortgage repayments should think carefully before gambling with interest rates and lenders’ whims. A fixed rate has the advantage that you can budget for the repayments, and be sure they won’t increase.

Those with lots of spare cash over and above the mortgage can focus simply on getting the best deal, whether it’s a discount (which often, but not always, work out cheaper in the long run) or a cheap fix.

Discounts are a gamble on rates

By taking a discount you’re taking a little gamble on how interest rates will move. The question to ask yourself, is ‘could I afford to lose?'. This means, if interest rates jumped, could you afford the payments comfortably? If you can, and the discount is cheaper, go for it.

Yet, if losing could mean financial disaster, stick with the fixed rate.

Don’t look back with hindsight

Now for something you’ll rarely read on this site. If you’ve gone for a fixed rate for surety, it’s often best to shut your eyes for a little bit. Regardless of what happens to interest rates, you wanted payment security and you’ve got it. Well done.

You can’t have hindsight in advance, so thinking "if only I’d..." doesn’t help anyone; unless you had a crystal ball. Even if it turns out it would’ve been cheaper to take a discount, that doesn’t mean going for a fixed rate was the wrong decision. Think of it a bit like this...

The wrong answer isn’t always the wrong bet.

Let me offer you a bet on a simple head or tails coin toss. Yet with one big change... if you win I’ll give you £100, but if I win you only need give me one pound. No con tricks, no sleight of hand.

Now first of all let me say, for the sake of my own pocket, this is only an analogy, the offer isn’t real. Yet think through the concept for a second. Would you take the bet?

The answer, for most people who can comfortably afford to lose a quid, is yes. While the nature of the bet doesn’t change the 50-50 odds, it means the downside is small, you’d only lose a pound; while the upside is huge, you’d get £100. So almost certainly, if you can afford to lose the pound, you should take the bet.

So let’s toss the coin....... YOU LOSE!

The fact you lost doesn’t mean it was a bad bet.

The same is true with taking a fixed rate. If you are doing it because personal circumstances mean surety counts, if the facts after the event show a discount would’ve won, that doesn’t make your choice wrong.

It’s the overall rate that counts

As rates change over time, simply comparing the fixed and discount rates at the point you take your mortgage is a relatively blunt tool. To work out which is truly a better deal, you need to look at how much interest rates would need to change before one deal beat the other. If you’re interested in this slightly more sophisticated approach, read this analysing the rate differences briefing.

Should I ditch my fix?

A. October 2008 saw the start of an unprecedented period of interest rate cutting, leaving UK base rates at the lowest level since the Bank of England was founded in 1694. Prior to that, rates tended to move 0.25% a time; then cuts of 0.5% and even more became common, in a desperate attempt to stave off the worst effects of recession.

This leaves many locked into fixed rates that are a good few percentage points above those on tracker deals, and unsurprisingly asking "can I ditch my fix?" Yet for many the answer is that doing so is UNLIKELY to save you cash.

Most importantly, this is because while existing trackers have plummeted, the top new customer deals are more expensive, usually cost a fee, and ditching involves a paying a hefty penalty anyway. There are a number of variables that impact this:

• Loan-to-values (LTV). Only those borrowing LESS than 75% of a home’s current value are likely to get competitive deals.

• The penalty. Most fixed-rate deals have big penalties if you leave early. Yet a £1,000+ penalty could be worth paying, for a really big cut in rate.

• The go-to rate. It's possible the standard variable rate the mortgage'll go to when the fix ends is cheaper than new deals anyway, and won't cost a fee. And thus waiting for this may be far cheaper

• When it ends. If your deal ends within a few months, it's unlikely to be worth paying a penalty. Yet ditching & switching's more attractive if you've longer left.

Similar logic would also apply if you were locked into an overly expensive tracker and wanted to ditch that.

The 'Should I Ditch My Fix?' Calculator

This calculator works out what interest rate you’d need to get to make it worth ditching your fix. If the answer is negative, it simply means it’s not worth it. Mortgages are complex though, so take this only as a rough ready reckoner.

The calculator doesn’t take into account ‘arrangement fees’ on new mortgages. If you are going to have to pay one, then the interest you need to make ditching your fix worth it would have to be even lower than the one quoted by the calculator

Outstanding Mortgage

£

Current Interest Rate

%

Early repayment charge? (ERC)
(pick % or £)

£ %

How long until the charge ends?

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Months

Add ERC to new mortgage?

Yes No

New lender paying valuation/legal costs?

Yes No

Calculations powered by London & Country

What to do if you CAN save

If the tool tells you it is possible to ditch, switch and save, it's time to make your checking serious

• Are deals that cheap available?
  
  The rate you need to achieve to make switching worth it may not be possible in the present market, or you may not have a low enough LTV to successfully apply for it. To find out what's available, speak to a whole-of-market mortgage broker, who'll scour the market and find the best deal possible for you. Read the Cheap Mortgage Finding guide for full details.

• Do the numbers properly
  
  This calculator is a rough ready reckoner to give an indication whether you may be able to save. Yet the details will be more complicated, with arrangement fees, mortgage exit fees, legal and valuation charges all possibly skewing the balance. To be sure, use a broker to do the sums, and read the free full Remortgage Guide to walk you through the process

• Think through whether you really want to lose a fix?
  
  If you got the fixed rate for surety, are you truly sure you want to get rid of it? This is especially true if the saving is small or you're planning to move to a variable rate. As recent interest rate history has shown predicting one way or another is a nightmare. It's not simply a case of lower cost right now is the best deal, think about your situation over a longer period.

Discuss this/Report your result: Should I Ditch My Fix?

What is a mortgage collar / minimum rate?

A. Tracker mortgages are supposed to follow the base rate as it drops (or rises). Yet some limit the minimum amount you will pay, so the rate can never go lower than a certain level. This works in one of two ways, though both have the same end result.

• Collars
  
  A collar sets the minimum amount the lender will consider the base rate to be. Imagine a tracker 1% point above base rate but with a 3% collar. No matter how far below three percent the base rate drops, you will still pay 4% (the 3% collar plus 1%).

• Minimum Rate
  
  Here the restriction is imposed on your mortgage interest rate, rather than the base rate. Imagine a tracker 1% point above base rate but with a 3% minimum rate. If the base rate drops below 2%, your rate will remain at 3% (as that's the lowest it can go).

Fight collars

The regulator, the FSA, says collars (and it’s likely this applies to minimum rates too) may be invalid if they "weren’t in the Key Facts Document (KFD) when you got the mortgage". Therefore do the following...

• Check if your mortgage has a collar. Simply call up and ask if it has a collar or a minimum rate, then follow below. If not, there's no issue.

• Find your key facts document. You should’ve got this when you first got your current mortgage deal. If it doesn't mention the collar or minimum rate, then you can argue it's invalid.

• Call it up and put a note on your file. If it’s not in the Key Facts Document, call up the lender now and ask for a note of dispute to be added to your file to say you do not accept the collar (or MR). If rates do drop below that and they activate the collar, put in a free complaint to the Financial Ombudsman.

Lenders affected

The following is a list of lenders that MAY have collars or MRs on their tracker rates, in late 2008. We've deliberately kept the older information (they are correct for December 2008's collars on most mortgages), as people on the tracker deals at that time will be the most heavily impacted by collars.

As the base rate has continued to plunge since Dec. 08, new tracker deals taken out since may have much lower collars, or none at all. Plus, there is no guarantee this list is exhaustive, other lenders may have collars or MRs too. If you're unsure, the best way to check is give your lender a call.

How are fixed rates priced?

A. 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. A very simple way to think of it is the fixed rate is priced due to the financial community's view of what’ll happen to interest rates over the fix period. So it’s possible base rates could be going up in the short term but fixed rates are coming down as the long term trend is different.

Lenders price their deals according to the cost of money they go out and buy on the wholesale money markets, and the credit crunch means this has got a lot more expensive than base rates.

Fixed rates tend to be sold in tranches, ie. a lender will put, say, £50 million worth of mortgages out there at a rate, and once it’s gone, it’s gone. This means if fixed rates are generally moving up, move quickly and you may be able to secure some of the old tranche before it sells out.

While this divergence of fixed rates and base rates can insulate you 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’.

What does a mortgage APR mean?

A. This is a common confusion for people getting mortgages out. They’re often advertised with two rates, the higher one is usually the APR. This is because lenders are forced by regulation to include it.

While the reasons behind APRs are good, actually in many mortgages they’re not that relevant. The Annual Percentage Rate is the equivalent interest cost over the FULL TERM of the loan, including all interest and fees

For example, a two year fixed rate at 3% may have an APR of 6%. This means if you kept the mortgage for the full twenty five years, you’d pay the equivalent of six percent a year. APRs have traditionally been higher because Standard Variable Rates are set higher than the short term introductory deals like fixed or discounts; plus any legal, valuation or other fees need including.

Yet if you’re not planning to keep the mortgage deal for long, and are only borrowing a smaller portion of your home’s value, meaning you should be able to continue to remortgage, it’s best to focus on the short term rate and the fees, mostly ignoring the APR.