Getting a mortgage is one of the biggest financial commitments you're ever likely to make. So it's crucial to understand what type of mortgage will suit you best.
This guide outlines the different types of mortgages available and helps you decide which one is right for you.
In this guide
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Choice 1: Repayment vs interest-only mortgages
There are three types of repayment structures: interest-only, capital repayment and 'part and part' (which is a mix of the two).
What is a repayment mortgage?
Your repayments are calculated so you'll have repaid all the debt and the interest over the term you agree (eg, 25 years). It means your monthly payments both cover the interest and chip away at the actual debt, so at the end you owe nowt.
This has a strange effect. In the early years, your outstanding debt is larger so most of your monthly repayments go towards paying the interest. Gradually, as you reduce what you owe, most of your repayments go towards paying off the debt.
What is an interest-only mortgage?
Interest-only mortgages used to be really popular among first-time buyers but since the credit crunch it's highly unlikely a wanna be homeowner will be able to get their hands on one. And new laws that came into effect from April 2014 mean interest-only mortgages will only be offered where there's a credible plan to repay the capital, making them even rarer.
But here is how it works...
Here, you just pay the interest during the term. Your monthly payment doesn't chip away at your actual debt – it just covers the cost of borrowing the money. When the term (typically 25 years) is up on a £150,000 loan, you would still owe £150,000.
So repayment wins hands down?
Putting the fact that it's difficult getting an interest-only mortgage aside, unless you have a compelling reason, repayment is really the way forward. Although you pay more each month, it's the only option which guarantees you owe nothing at the end of the mortgage term, as you're actually paying off some of your debt every month.
And as the capital is gradually reducing, you pay less interest over the term than you would with an interest-only mortgage. When you come to remortgage, you'll have paid off more of the debt so you'll be able to get a mortgage with a lower LTV and hopefully a lower interest rate.
Choice 2: Is a fixed or variable rate mortgage better?
This is the really BIG choice, and it's never easy. There are many different types of deal but all fall roughly into two camps. They're either fixed or variable.
What's a fixed-rate mortgage?
Think of a fixed rate like this. In return for signing up to it, the lender agrees to give you a short-term special rate. Regardless of what happens to interest rates, with a fixed mortgage your repayments are… er… well… fixed for the length of the deal.
Lenders call this the incentive period - and all fixed deals will have one, whether it's two, three, five or 10 years.
What is a variable rate mortgage?
Here your mortgage rate, as the name suggests, can and will usually move up and down. The major, but not sole cause of this, is changes to the UK economy.
In times of growth and inflation, interest rates tend to go up to discourage spending. This is to make saving more attractive and borrowing costlier – meaning people are less likely to borrow to spend. In downturns, interest rates are often cut to encourage spending.
To complicate things, variable rate deals fall into three categories: trackers, standard variable rates (SVRs) and discounts.
Here, the rate tracks a fixed economic indicator - usually the Bank of England base rate. This doesn't mean it's the same as the base rate, just that it moves in line with it.
Standard variable rate mortgages (SVRs)
Each lender has an SVR that they can move when they like. In reality, this tends to roughly follow the Bank of England's base rate movements. SVRs can be anything from two to five or more percentage points above the base rate, and they can vary massively between lenders.
Discount rate mortgages
These deals usually offer a discount off a lender's standard variable rate (SVR). Most of the discounts on offer tend to last for a relatively short period – typically two or three years, but there are lenders offering longer, even lifetime options.
The fixed/variable option - should I go for a capped deal?
A capped deal is a variable rate, a discount or a tracker mortgage which has an upper limit- so the rate has a guaranteed ceiling it can't exceed no matter what the tracked rate rises to.
They tend to be offered most often, and are most popular, when people are frightened that interest rates could soar.
Choosing between fixed & variable
A fixed rate is an insurance policy against hikes and therefore gives peace of mind. That has to be factored into the equation. Though how much that peace of mind costs you is important too.
Yet a shock horror thought from the Money Saving Expert. Here, choosing a rate isn't purely about which is the cheapest.
Deciding whether to fix is a question of weighing up how important certainty that your repayments will stay the same is for you. I tend to think of this as a "how close to the edge are you?" question.
Someone who can only just afford their mortgage repayments should not be gambling with interest rates. They'll benefit much more from a fixed rate as it means they'll never be pushed over the brink by a rate increase during the term of the fix.
Those with lots of spare cash over and above the mortgage may choose to head for a discount or tracker, and take the gamble that it'll work out cheaper in the long run.
Don't look back in anger
I'm sure Oasis were writing about mortgages when they penned that famous line. The truth is, the only way to truly know which mortgage deal is best is with an accurate crystal ball, and they cost way more than a house.
So if you do decide to go for a fixed rate on the basis of surety and later with hindsight 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.
I think it's time for an analogy
If I asked you to call heads or tails on a coin toss and said I'll give you £100 if you win, but you only need to pay me £1 if you lose, then provided you could afford to lose £1, you'd be a fool not to do it.
While the bet itself doesn't increase your chances of winning, the reward for winning is much better than the cost of losing. So if when we actually tossed the coin you lost, that doesn't mean the bet was a bad one. Even though the outcome wasn't what you wanted, you made the best decision based on the knowledge you had at the time.
The same is true with fixing your mortgage.
What's the difference between a tracker and a discount mortgage?
A tracker follows the Bank of England base rate (or less commonly, the Libor rate) which is an independent economic indicator. This means your lender should only move your rate by the same amount and when the indicator moves. (Check the small print to make sure your lender hasn't left itself a loophole here – very rare, but it has happened!).
A discount is priced at a certain percentage below the lender's Standard Variable Rate. The percentage discount cannot change but the SVR, can move willy-nilly based on the lender's 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.
Why do some variable mortgages have a 'collar'?
Between July 2008 to March 2010, the Bank of England base rate dropped from 5.75% to 0.5%. Tracker products were usually priced below base rate (eg, base rate minus 0.2%) so some borrowers did extremely well. But the lenders didn't do quite so well out of it, so some tried to limit their losses by applying a mortgage collar (minimum rate).
A collar stops the rate from falling below a minimum percentage rate - essentially, it's the opposite of a cap. Some lenders were sneaky and introduced this even though it wasn't in the paperwork, though this isn't allowed.
If you opt for a variable mortgage, make sure you check if there's a collar. Ask your lender (or broker) outright AND check the key facts illustration and mortgage offer carefully.
How do I know if I'm getting the best deal?
As rates change over time, simply comparing the fixed and variable rates at the point you take your mortgage is a relatively blunt tool. To work out which is truly a better deal, look at how much interest rates would need to change before one deal beats the other. This is where a broker can really help you see the wood for the trees.
Choice 3: What length of deal should I choose?
Incentive periods range from two to 10 years and picking the wrong length can be costly. Yet many don't think this through fully. This can come back to bite you later, meaning you spend more than you need to.
There are many factors to consider before you choose, the key one being...
"How long do you need the surety for?"
This is most appropriate with a fixed-rate mortgage, as your monthly payments are fixed for the term. Generally speaking, the longer you fix for, the more it will cost. But if you need the certainty of knowing what your payments will be, a fixed mortgage will do this for you.
Mortgage fees can add up if you constantly switch deals
Two-year incentive periods are extremely popular because they're usually the lowest rates. But their fees tend to be just as high as longer deals. So think about it - over 10 years, if you have five separate two-year deals, you could be paying £7,000 in arrangement fees (£1,500/deal).
But if you can get two five-year deals, then you'd only need to pay £3,000, potentially saving £4,500.
How long should I set the term for?
As well as choosing the length of your introductory deal, you also need to choose how long the mortgage will run for. It's an important factor, and it's often overlooked.
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Watch out for early repayment charges
If you think about it, a fixed or discount deal is a special offer - a reduced rate from the lender in the hope that once the cheap price ends, you'll stick with it and maybe even pay more (sometimes you'll actually pay less).
Choice 4: Do I want my mortgage to be flexible?
Once you've got an idea of the key requirements for your mortgage, the next question is: do you want a mortgage that's more flexible?
This means getting functions that allow you to over-or underpay, and borrow money back. Sometimes flexible features are included in the cheapest mortgages already, which is an added bonus.
Other times, you might need to take a higher-rate product to get the feature you want. You'll need to weigh up what you definitely need, what depends on cost and what doesn't matter as you'll probably not use it.
Flexible feature 1 – Can you, and should you, overpay?
Far more important than the others, is the most popular flexible feature - the ability to overpay. This just means paying more than your agreed monthly repayment – whether each month or just shoving a lump sum at your mortgage from time to time.
Flexible feature 2 - Can you take payment holidays?
Here, the lender will allow you to simply stop paying it when you want. But be careful. Lenders don't let you play hooky from the goodness of their hearts.
Flexible feature 3 - Offset and current account mortgages
So far, the focus has been on mortgages that are variations on a 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, so straightforward.
Choice 5: How do joint mortgages work?
When you take out a joint mortgage, the lender classes you both as 'jointly and severally liable' for the debt. This means the lender can pursue you both, or either of you separately, for the full debt.
Choice 6: Are guarantor mortgages worth it?
If a mortgage lender isn't willing to lend you the amount of money you need (you don't earn enough, or it thinks you'll be stretching your affordability too far), a guarantor mortgage could get you the loan amount you needed.
A guarantor is somebody who promises to make your mortgage payments if you fail to do so. They don't own the property so are not on the title deeds, but they have signed a legal contract with your mortgage lender.