Understanding The Different Types Of Mortgages
It is no exaggeration to suggest that choosing the right type of mortgage could be a life-changing decision. You can potentially save yourself thousands of pounds by choosing the product that best suits your circumstances, and being trapped in a deal that isn’t working for you can set you back a number of years in your financial development.
This can put an awful lot of plans on hold and can start to affect work and family life, so getting the right advice and doing your research is very important.
There is an awful lot of choice when you start to look at mortgages on the market, and it can be a daunting prospect. However, amongst the hundreds of products available, there are only actually a handful of different types of mortgage, they are then given different names by each lender and are loaded with different terms and rates etc.
So here, as an introduction to your research, we will look at the main standard mortgage types, how they differ and what their pros and cons are.
How do mortgages work?
First and foremost you need a mortgage to buy a property, unless you are fortunate enough to be able to buy a property outright. In most circumstances you will need to save up a deposit for a home, and then the balance is paid off using a mortgage.
So the house you want to buy is £180,000. You have £20,000 for a deposit, so you need a mortgage for £160,000.
If you already have a home, you would use this existing property as ‘equity’ in place of a deposit, but you would still need a mortgage for the remaining cost price of the new property.
So the house you want to buy is £280,000. You sell your house for £200,000, so you need a mortgage for £80,000. (Most likely you will need to borrow more than £80,000, because some of the £200,000 you receive for selling your original home will need to contribute to paying off your original mortgage).
Traditionally, lenders have offered mortgages on a repayment or interest-only basis. By far the most common type at the moment is repayment, and this is what we will concentrate on here.
Repayment mortgages work on the basis that you pay a monthly payment which comes off the amount of money you have been loaned, on top of this you also pay an amount of interest, until the whole loan amount is paid off.
Repayment mortgages offer much more certainty, in that – whichever mortgage product you choose – you are guaranteed to be paying off your debt with each monthly payment. At the end of the mortgage term you know your debt will be settled, and if you are still living in the same house, you will own it outright. This is a nice feeling to have.
Interest-only mortgages are not very common now, but they were very popular in the 1990s. With these you pay only the interest payment on a monthly basis, so the amount you owe – ie. the cost of the property – remains the same over the term of the agreement.
It is up to you to make arrangements to pay this debt off at the end of the term, and most products did this via a form of investment, such as a life assurance policy which would mature at the same time that the mortgage term ended. Interest-only mortgages were popular for a short time because the monthly payments were generally much lower, but it was something of a gamble as to whether you could pay the debt off at the end of the term. And you therefore ran the risk of losing your home, so their popularity fizzled out.
Fixed and variable mortgages explained
Lenders will only lend you money if they get something in return, this is interest and is the unavoidable reality of taking on a mortgage, ie. you have to pay back more than you borrow. There are generally two types of mortgage, and these differ by how this interest is calculated. These are known as fixed rate mortgages and variable rate mortgages.
Within each category there are various products and various advantages and disadvantages, which we will look at below. But fundamentally, a fixed rate mortgage will be a deal where you pay the same amount of interest for a set period, regardless of other interest rates such as the Bank of England Rate or a lender’s own standard variable rate. These set terms tend to be between two and five years.
Variable rate mortgages are usually split into tracker mortgages, standard variable rate mortgages and discounted mortgages. But generally speaking, a variable rate mortgage will follow a certain base interest rate, which could go up or own, so the amount of your monthly payment is not guaranteed or a ‘fixed’ amount.
Fixed rate mortgages
A fixed rate mortgage guarantees a certain interest rate for a set period of time. This interest rate will be what the lender is offering at that moment in time, but will be set in stone and won’t change.
This set period is known as the ‘initial period’ and can be between one and ten years, but is typically between two and five years. After this, your rate will switch to the default variable rate that the lender is offering at the time, or you can renegotiate a re-mortgage deal, which is the agreement of a new deal with your lender.
Fixed rate mortgages are by far the most popular mortgages for most people.
Your monthly payments are fixed and won’t change.
You know that your monthly payments won’t rise for the initial period, and the longer the set period – ie. around five years – then the more certainty you have.
You may end up paying more for your home overall than you need to.
You may end up paying more than the standard variable rate of interest, if this reduces during your fixed period. So you won’t benefit from the fixed rate and may feel trapped. If you take on a longer set period (ie. five years or more) then a lot can change during that period, your income or stability may improve so you could potentially pay more on a monthly basis, and hence, on a different mortgage deal you could be paying off your mortgage quicker. Also, after the first couple of years of home ownership, many of the big expenses have passed, so your mortgage payments may be more affordable, so shorter fixed terms of two to three years are more popular.
Best suited to:
Fixed rate mortgages are most popular with people who need stability and need to know exactly what they are paying each month. This is particularly good for people on a tight budget, but can suit people with more disposable income also.
Variable rate mortgages
This is a popular type of variable mortgage where you pay off a set amount of your debt each month, plus an amount of interest which is calculated by following an agreed interest rate. This is most often the Bank of England base rate.
So if this was 0.1% for example, you would pay an interest rate agreed with the lender – let’s say 3% - plus 0.1%. So you might be paying 3.1% for the first part of the set period, but if the Bank of England rate goes up to 0.3%, you would pay 3.3% interest. Equally, the base rate you are tracking may go down.
At the end of the set period, most people move to a standard variable rate mortgage, but it is possible to get a lifetime tracker, which means you follow the same base rate of interest for the whole lifetime of the mortgage, which could be up to 25 years. So be sure to know what happens at the end of a tracker period and what your options will be at that point.
Some trackers have a ‘cap’ and a ‘collar’ attached, which means your monthly payment tracks this base rate, but won’t go above an agreed rate or below an agreed rate.
If the base rate you are following goes down, so does your monthly payment.
If the base rate your mortgage is following goes down, then your monthly payment reduces by the same amount. Also, your monthly payment is only affected by the interest rate you are following, so if the lender’s standard variable rate goes up, but your mortgage is tracking the Bank of England base rate – and that stays the same - then your monthly payments will be unaffected. A big benefit of the tracker mortgage is that it is totally transparent, and while the interest rate can go up or down, you can see this happening and be prepared for it either way.
Can be unpredictable and you may end up paying more than you need to.
Best suited to:
A tracker mortgage is perhaps best suited to people with a little more leeway and comfort in their monthly income and can therefore accommodate potential increases in their monthly payments. Typically this will be a more mature or experienced homeowner who has been on the property ladder for five years or more. But in truth, anyone with a stable income who can accept a small increase if and when it happened – even a first time buyer – could cope with a tracker mortgage.
Standard variable rate (SVR) mortgage
This is a lender’s default mortgage rate with no deals and limited flexibility attached, it can have a different brand name according to the lender, but the basis of a SVR mortgage remains the same whoever the lender is.
The SVR is the rate which most deals will revert to once a ‘fixed rate’ or ‘tracker’ period has ended. The rate is set by the lender and can be changed at any time, and hence tends to be a slightly higher rate than is offered by most tracker deals, so it is worth shopping around for better deals.
With a SVR deal, the lender is relying on people not being too bothered about doing their research and going through the hassle of moving to a better deal, this puts the lender in charge and gives them the freedom to change the SVR at will.
You can save money initially on a SVR at the end of a fixed or tracker period.
The SVR can go up as well as down, and it is possible that you will end a ‘fixed rate’ or ‘tracker’ period on a higher interest rate, and then save money initially by defaulting to your lender’s SVR.
Your lender has freedom to increase the SVR at any time.
The lender is in charge and can change the SVR at any time, so you have much less control. Although the SVR is not linked to the Bank of England base rate, it often follows its trends, and hence if the Bank of England rate is predicted to go up, then most SVR’s will go up accordingly. Because your repayments can change at any time, you should be prepared for the fact that you will most likely pay more money over the course of your mortgage term than if you chose to shop around.
** Best suited to**:
A SVR is suitable to you if you can cope with increases in your monthly payments, and you aren’t too bothered about researching new deals to save money each month. You still know you will be paying off your mortgage at the end of the term, but you can accept that you might be paying more for it.
Some lenders will offer an initial discount period on their SVR, and this is known as a discount mortgage. So if you agreed, say, a 1.5% discount, then if the current SVR with your lender was 4%, then you would be paying 2.5% interest each month. However, if the SVR increased to 5%, you would be paying 3.5% interest. So the discounted percentage stays the same when the SVR increases or decreases. Some lenders may use the ‘cap and collar’-type agreement that you see with tracker mortgages to control how low and how high your payments become.
You are always paying less than the SVR.
Your interest rate will remain below the SVR for the duration of your agreement, so it will always be competitive against the wider mortgage market. When the SVR is low you will have an excellent deal that will be difficult to match elsewhere.
Your monthly payments can still increase as per the SVR.
The lender can still change the SVR at any time, so your mortgage payments can still increase, albeit they are discounted. Some lenders may use the discount mortgage to attract customers to their SVR and then put the SVR up when your discounted period ends. Your discount is only available for a set period, so you need to be prepared for your payments to increase at that point.
Best suited to:
A discount mortgage is good for first time buyers or new homeowners who will face a lot of costs for the first couple of years. They can therefore take good advantage of the discount knowing they will be able to accommodate the increase in payments once these initial costs are dealt with.
Other types of mortgage
These are less common types of mortgage or are a less common feature within a standard mortgage deal. If you shop around you may find these deals being offered by certain lenders, often on a short term basis.
You should also be careful, in that some very attractive terms are often countered by terms and conditions in the small print, so be sure to fully understand what you are signing up for. These kind of deals are often dictated by unusual or rare market conditions, or are tailored towards specific borrowers.
Flexible and offset mortgages
A flexible mortgage is where you can overpay or underpay on your monthly payments or even take a short holiday from paying anything at all. But this flexibility comes at a price of higher interest rates, and usually you can only over-pay by a maximum of 10% annually.
An offset mortgage is another flexible mortgage where you can use a savings account with the same lender to offset your mortgage payments.
This means that if you owe £150,000 on your mortgage and have £20,000 in a savings account with the same lender, you only need to pay interest on £130,000, and hence your interest payments will go down.
You will not earn any interest on your savings for the period that it is ‘offsetting’ your mortgage, however, and you will have to pay a slightly higher interest rate also.
First time buyer mortgages
Some lenders offer tailored packages to first-time buyers who are struggling to get onto the property ladder.
They are similar to a standard mortgage but will require a lower deposit, lower application fees and often have the early years discounted to help the buyer in that initial costly period. However, you should be careful in that the overall deal may not necessarily be the best deal around, and the benefits offered may not be better overall than a much lower interest rate elsewhere.
This is a mortgage specifically for landlords who wish to buy a property to rent out. Because this is based on property investment and a ‘second property’ it carries more risk for the lender, and hence while this is a standard mortgage, it will most likely have higher interest rates, higher fees and require a higher deposit.
However, your monthly payments can be covered by the rental income you will receive when renting the property out. This therefore controls the amount of money a lender will let you borrow, so you need to calculate your expected rental yield % accurately.
A buy-to-let mortgage is only available if you already own a property, are above a certain age and have a good credit record, and hence can guarantee the repayments. You also need to declare that you understand the risks involved in property investment before a lender will allow you to apply for a buy-to-let mortgage.
This is similar to a buy-to-let mortgage in that it is secured to pay for property that is not residential. Businesses or a landlord can take out a commercial mortgage for a term between three and 25 years, and typically there will be no fixed rates and there will be higher interest rates to reflect the higher risk the lender is undertaking.
Businesses can of course take out a business loan, but these are typically only available up to £25,000 and hence the commercial mortgage takes over at that point. However, a commercial mortgage will usually come with a better interest rate than a business loan, because the property itself acts as security.
Another benefit of a commercial mortgage to a business is that the interest payments are tax-deductible.
Capped rate mortgages
In favourable market conditions a lender may offer you a capped rate mortgage, this is a variable rate mortgage but with a cap on how high the interest rate can go. You typically face a higher interest rate than with a tracker mortgage, but you are effectively paying for the peace of mind that comes with knowing your interest payments cannot go above a certain point.
These are a feature of a standard fixed or variable rate mortgage, whereby a lender gives the borrower a lump sum payment as an incentive to take the mortgage out. This is typically between £500 to £1000 and is often aimed at first time buyers who face a lot of initial costs when taking on a property.
The cashback gift is not repayable, but the borrower will typically face a higher interest rate, so you would need to calculate the overall cost of the mortgage to assess whether the cashback payment is sufficiently useful. In the short term – and faced with a lot of costs - you may deem that it is.
Understanding the different types of mortgages
To fully understand the mortgages currently available you should speak to a professional mortgage broker, as they will have a good knowledge of the current deals available, and may even have access to some exclusive deals. Be aware, however, that sometimes brokers have an incentive to promote certain packages and products, so you still need to fully understand the deal yourself and do your research to establish how good a deal it really is.
Trusted, independent advice is always valuable, particularly as the mortgage market can be a minefield.
You would also be advised to speak to your current bank and/or building society. It is possible they will offer you additional incentives on a mortgage as an existing customer, but always be sure you understand the full extent of the deal and what you are signing up to.