When you look at the mortgage market, you will see there are mortgages in all shapes and sizes, meaning you have many options to choose from. This is great because it means you can find one that is the perfect fit for your circumstances.
Having said that, it can also make the process of identifying the right one rather complicated. Every mortgage type has its own set of features, with some more suited to certain lifestyles and situations than others. If you aren’t an expert, how can you know which will be best for you? Would you be better off with a repayment mortgage or an interest-only one? Are any special features needed for your circumstances? There is much to consider and it can take time to fully understand what’s available.
It can feel like you’re being bombarded with options – fixed, discounted, flexible/offset, tracker, and products aimed at specific sections of the market like first-time buyers, remortgagors, home movers, buy-to-let…it really can get very complicated.
If you’re going to understand what’s available, it’s not necessary to become an expert overnight. You just need to find yourself a starting point.
In this guide, we’ll help with the following questions
- Should I go with a repayment or interest-only mortgage?
- What type of interest rate should I choose – fixed, tracker or discounted?
- What additional features might be suitable for me?
Repayment vs Interest only Mortgages
Before you can make any decisions about the type of mortgage product you want, you need to understand the options for repaying your mortgage. The choice is between a repayment model and an interest-only one. In essence, you must decide whether your monthly repayments will incorporate both capital and interest, or whether it would work better to pay only the interest on the money you’ve borrowed and then pay off the actual loan later on.
With a repayment mortgage, the monthly payments you make will incorporate both capital and interest. You won’t need any other repayment vehicle.
A repayment mortgage is straightforward and simple to comprehend. There’s no need to be concerned with paying a lump sum off in one go and you sidestep the risks of investing in order to accumulate the funds to pay back (the ‘repayment vehicle’). As long as you keep up with repayments throughout the full mortgage term, your mortgage will be cleared and you will own your home outright.
There is no chance of benefitting from a potential rising investment in the stock market. Also, if you remortgage, you will likely choose another long-term repayment mortgage to keep monthly costs low. The result is that the overall term of the mortgage increases, so its total cost does too.
Interest only Mortgages
When you choose an interest-only mortgage, the monthly payments you make cover only the interest on the loan. None of the capital is repaid. This means the full amount remains outstanding and must be cleared at the end of the mortgage term. You can make the repayment early, subject to the terms and conditions of the mortgage deal.
Lenders will need to feel confident that you can make the lump sum repayment at the end of the mortgage term, so you will need to demonstrate a repayment plan. Typically, these include investment funds, ISAs, pensions or equity in other properties you may own. This is called a repayment vehicle.
There are many repayment vehicles to choose from, some of which offer certain tax advantages. What’s more, if you choose to move or remortgage, you can usually reallocate your investment vehicle to the new mortgage. It’s important to speak to an investment adviser if you are considering this route.
Unlike with repayment mortgages, the total amount of your debt does not reduce over time. Also, there are no guarantees that your investment vehicle will grow enough to pay off your loan, though you can add to your contributions to investments over time if it’s looking likely that there will be a shortfall. You can also ask your lender to convert some or all of the mortgage to repayment to make up for any investment shortfalls.
Note that lenders who offer interest-only mortgages will usually only do so up to a certain loan-to-value limit (currently 75%).
Mortgage Interest rate options
Once you’ve come to a decision about repayment or interest-only products, you will need to turn your attention to the interest-rate options. Lenders offer several different types of interest rate on their products. There are pros and cons to each, which will depend on your unique circumstances – what looks like a benefit to you might look like a disadvantage to someone in a different situation. As a result, the mortgage type that’s best for you will depend on what fits with your current and future requirements.
Standard Variable Rate (SVR)
The simplest (and the original) type of interest rate is determined by the lender’s standard variable rate. This is the background rate at which the lender charges interest. They define it themselves and will usually adjust it in line with any changes in the Bank of England’s base rate. You must note that lenders have the power to set their SVR at any rate they choose, meaning it can be increased or decreased by whatever margin they see fit. It doesn’t necessarily have to be in line with changes made by the Bank of England.
Most borrowers automatically shift to their lender’s SVR once the initial, often promotional, rate period comes to an end.
In most cases, there are no early repayment penalties.
Interest rate movements are unpredictable, making it difficult to plan your finances. The cost of your mortgage could increase substantially if interest rates go up. What’s more, the SVR rates are often significantly higher than the introductory rates offered.
A discount rate mortgage essentially gives you a set discount off the lender’s SVR. Any changes in the lender’s SVR will result in your rate fluctuating accordingly but with the same level of discount. In most cases, a larger discount will only remain for a shorter period and, once the reduced rate period ends, your loan will revert to the lender’s SVR. This will mean your payments increase as the discount is taken away.
The savings you make can be substantial compared to the SVR as the interest you’re charged comes at a discounted rate.
The early repayment charges for discount mortgages are usually relatively high during the discounted period. This can make it rather expensive to remortgage to a different rate or lender if the discounted period hasn’t yet expired.
A fixed-rate is an interest rate that cannot change for a set period of time. Once you reach the end of that period, you will revert to the lender’s SVR. There are various time periods that fixed rates can stay in place for – 2, 3, 5 or 10 years, or perhaps even longer.
Fixed rates are usually highly competitive because they are a popular choice for borrowers. Lenders compete with one another for your business so they set the rates as low as they possibly can, meaning you have some very attractive options to choose from.
The fixed-rate doesn’t change during the set period, so you will always know how much your payments will be even if the Bank of England alters its base rate. This makes budgeting easier.
There is usually an early repayment charge on fixed-rate mortgages. Also, if the base rate is lowered, your rate will remain the same, meaning you may end up paying more than you would with a discount or tracker rate, which would reduce accordingly.
A tracker rate is one that automatically moves in line with the Bank of England’s base rate by a predetermined margin. That margin usually remains the same throughout the initial product period. Changes in your lender’s SVR will not affect a tracker rate.
Tracker rates usually track the base rate of the Bank of England by a specific percentage. For example, it could be set at the base rate plus 0.5% for 5 years or even the full mortgage term.
Many tracker products also come with flexible terms and are a great option if you want to take advantage of falling interest rates. However, you need to be confident that you would be able to afford an increase in monthly payments if the base rate rises.
A tracker rate enables you to instantly benefit from reductions in the Bank of England’s base rate. You will also find that they tend to be slightly cheaper than fixed rates.
If the base rate goes up, your tracker rate will do the same, and by the same margin. Tracker rates don’t have the same level of security as a fixed or capped rate mortgage.
In addition to having one of the interest types listed above, there are many mortgage products that include other special features.
At one time, there was a type of mortgage known as a cashback mortgage. In this type of deal, the lender would offer a percentage of the loan amount as a cash payout upon completion of the mortgage. These products usually stood at SVR for at least the first few years. Today, cashback is usually much smaller and comes as an added benefit on other mortgage types such as tracker or fixed-rate mortgages. When you choose a mortgage with a cashback feature, you will receive a lump sum upfront. This was once a fixed percentage of the overall mortgage value, but now it’s usually set within the range of £250 – £1,000, depending on the offer the lender is making. The cashback features on modern mortgages usually go towards things like survey costs or conveyancing fees.
When a lender covers the conveyancing fees they will select a solicitor to do the work, but a lender offering cashback provides you with the freedom to choose your own solicitor. What’s more, as you’re paying for it you may find you have more control over the solicitor’s contribution to the transaction.
You may have to take on the extra work of arranging key parts of the process, though Think Plutus can handle the work with solicitors on your behalf.
A droplock mortgage is a tracker or discount product that includes the option to switch onto a fixed rate with the same lender during the initial period. There will be no early repayment penalties if you choose to do so.
You can take advantage of the base rate when it’s low then switch to the security of a fixed rate in the event that the base rate rises significantly.
There is a similar level of risk as with a discount or tracker rate mortgage – it’s up to you to switch onto a fixed rate, which may be higher. You won’t get any recommendations from the lender regarding when to make the switch.
With an offset mortgage, your mortgage account is linked to a savings or current account. With this setup, you can offset the positive savings balance against your outstanding mortgage. The interest is calculated on a daily basis between the 2 accounts.
There are different setups for this: you can keep your monthly payments the same and let the term reduce, or you can keep the term the same so that your monthly repayments get lower. This is a very useful option for people with large amounts of savings or those who can afford overpayments. Higher rate taxpayers may find this a very appealing opportunity. Not all lenders are able to offer both methods of offsetting so you need to be clear about what’s available before you apply.
The more money you can contribute to the offset savings account, the less interest you’ll pay on the mortgage. You still have the ability to make withdrawals from your savings account whenever you need to.
An offset mortgage is more complex than a traditional product and, consequently, you may find that rates are somewhat higher.
Repayment methods for interest-only mortgages
When you opt for an interest-only mortgage, you are required to arrange a method of raising the money to pay back the capital once you reach the end of the loan period. This doesn’t have to be done with a repayment mortgage since you pay back some of the capital each month in addition to the interest charged.
There are many repayment methods to choose from for interest-only mortgages, including equity in other properties, ISAs or pensions.
You may have heard the word ‘endowments’ before. In the past, these were a very popular repayment option, but that is no longer the case. Nevertheless, we’ll provide a little background about them since some people are still using one that they started many years ago.
These are rarely used today, but there are still people who have one they set up in the past as a repayment vehicle. With endowment mortgages, borrowers make their monthly interest payments to the lender and make additional contributions to an insurance company in order to fund a savings plan. Eventually, this savings plan is intended to raise enough funds to pay off the capital when you reach the end of the agreed mortgage term.
Endowments can be ‘unit-linked’, ‘with profits’ or a combination of the two.
In a unit-linked policy, value is driven by the underlying value of investments made once the policy reaches maturity. In a ‘with-profits’ policy, there are 2 types of bonus. There is an annual ‘reversionary’ bonus that goes into the savings plan every 12 months and is usually guaranteed as long as the policy remains active until the policy’s maturity date. There is also a ‘terminal’ bonus that comes on the date the policy reaches maturity, the size of which will depend on how the fund has performed over its lifetime.
If you die before reaching the end of the term, the life insurance part of the endowment kicks in to clear the outstanding debt. People should review the level of cover regularly as mortgage balances do not remain the same in the long-term.
One advantage of an endowment is that you keep it if you change mortgage provider or move house. Endowments offer insurance cover for things like critical illness and life, usually in a cheaper model than you would get if you took out those covers separately.
There is no guarantee that the underlying investments in an endowment will perform as hoped. You may have to review the payments you are making to the endowment policy and the actual mortgage repayments you make to ensure you can still pay off the capital at the end of the agreed term.
Endowments are rarely used in the modern market except by people who took them out in the past and they are still active. Don’t be concerned with endowments if you are planning to start a new interest-only mortgage.
Equity in other properties
Today, lenders will consider any equity you have in other properties as a method of covering some or all of the capital in an interest-only mortgage. Some lenders will even consider ‘downsizing’ as a repayment strategy if the equity in your home will be sufficient. There are quite strict rules around this, so you are advised to consult your lender or adviser before considering equity in property as a viable repayment vehicle.
When an ISA is used as a repayment vehicle, you will make your monthly interest payments to the lender and simultaneously contribute to an Individual Savings Account. Tax-free growth for ISA mortgages comes from stock market-based investments.
The 2 main types of ISA are ‘Cash’ and ‘Stocks and Shares’. The rules regarding contribution levels and available investments vary for each type.
An ISA that performs well could yield enough money to pay off the mortgage early.
If the stock market doesn’t go your way, the value of your investment could actually decrease, leaving you with a shortfall at the point of maturity that you would have to find a way to fund.
If you choose a pension repayment vehicle, your monthly interest payments are made alongside contributions to a pension. This pension should eventually yield a tax-free lump sum in addition to a taxed regular income when you reach retirement. You will use most, if not all, of the tax-free lump sum to pay off the capital of your mortgage when you retire.
Pension contributions are eligible for tax relief up to 40% for higher rate taxpayers. This means every pound you contribute to your pension will increase in value.
When you use your tax-free lump sum as a repayment vehicle for an interest-only mortgage, you may be left with a retirement income that isn’t enough to live on. What’s more, the lump sum can only be paid when you retire, so you could end up with a loan term of more than 25 years, depending on your age and when you plan to retire.
The biggest problem with a pension repayment vehicle is that the amount of the tax-free lump sum could be adversely affected by poor performance. This would leave you without enough money to pay off the loan when the term ends, as well as inadequate income for later life.
Other mortgage types explained
There are many different types of mortgage in the market, making it very difficult for the average person to understand everything available. Though there are many choices, they all fall into some combination of the things listed above.
Many mortgages have different names but their base elements are the same, while some products can only be provided at certain rates to selected types of borrower. These people could be first-time buyers, existing borrowers looking to remortgage or move home and those with buy-to-let mortgages.
Navigating the ocean that is the mortgage market is tough on your own, which is why Think Plutus is here to guide you through all the variables and complexities. Our mission is to help every client zero in on the best deal for their circumstances, and we urge you to contact us today if you are feeling confused or uncertain about anything. For mortgage advice that takes away the complexity of understanding different mortgage types, Think Plutus.