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What type of mortgage should I choose?

Posted 19 May 2017 by Ben Salisbury

Selecting a mortgage is the most important financial decision most of us make so understanding the various types will help you choose the right one for you

Sometimes too much choice means making a decision becomes more difficult, but when it comes to choosing your mortgage, a mistake can become an expensive one, so it’s vital to understand the different types of mortgages available, how they work and the pros and cons of each so you choose the right type for you.

From fixed rate mortgages for the risk-averse, which set your monthly repayments at one amount for the whole term of the mortgage product to interest-only mortgages where you don’t repay the capital, only the interest, there are various kinds of mortgages that suit different types of borrowers.

Initially you will have to decide on whether to choose a fixed rate, where your monthly repayments won’t change or a variable rate mortgage deal where your repayments could go up or down, over a certain set period, normally two, three or five years.

With all mortgage types and deals, the rate you get depends on the level of equity you have in the property. If your home is valued at £280,000 and you need to borrow £210,000, 80% of the asking price, then you have a deposit of 20% and a loan-to-value (LTV) ratio of 80%.

The lower the LTV ratio, the lower the rate on the mortgage deals you will be able to qualify for. Once you get to below 60%, the cheapest deals on the market are open to you.

The impact on what you pay on any deal depends on how much you are borrowing. The more you borrow the more impact a change in interest rates will have.

For example, if you owe £150,000 an increase of 1% on the interest you repay will cause your monthly repayments to rise by around £100 a month. If your mortgage is only £75,000 a similar rate rise will only lead to an increase of around £50 in your monthly repayments.

Repayment or interest-only?

Repayment mortgages mean you repay the capital as well as the interest. You normally pay more in interest at the start of the term and the balance changes over time as the capital gets repaid and less interest is charged. With an interest-only mortgage you only repay the interest meaning monthly repayments are lower but you still owe the money you have borrowed.

Fixed rate mortgages

With a fixed rate mortgage you agree to pay a set interest rate which does not change over the length of the product.

These types of mortgages are good for people who are on a tight budget and are risk-averse and like to know exactly what they have to pay for the length of the fixed rate mortgage deal they’ve signed up for.

You pay a slightly higher premium the longer you take out a fixed rate deal for. So, for instance, you might pay a rate of just 1.50% for a two-year fixed rate deal, rising to maybe 3% for the certainty of a five-year fix.

This is because lenders are in effect gambling on the state of the economy and the Bank of England’s policy on interest rates. So, the longer the deal, the higher premium you pay for fixing.

The rate you get on any mortgage deal depends on the proportion of the property you already own, known as the equity you have in the property.

Variable rate mortgages

There are two main types of variable rate mortgages; tracker and discount rate mortgages.

The interest rate on tracker mortgages are linked to the Bank of England’s base rate and they track it, so for instance, you might take out a tracker deal that charges an interest rate at the base rate, currently 0.25%, plus 2%, so you would pay 2.25%.

Normally with a tracker mortgage you start off on an introductory rate and are eventually moved onto the lenders standard variable rate (SVR). However a minority of tracker mortgages are ‘lifetime trackers’ that track the Bank rate for the lifetime of the entire mortgage.

Borrowers who took out a lifetime tracker deal a year or two before the financial crisis of 2008, ahead of the Bank of England lowering the base rate to 0.50% in March 2009 made what turned out to be a very financially rewarding decision.

At the start of 2007 base rate was 5% and it stayed at this rate or higher until early October 2008. Because it was relatively high, the premium added on was low, so many borrowers were on base rate plus 0.5%. This meant that in the months from October 2008 to March 2009, when base rate fell dramatically to 0.5% where it stayed for the next seven years, those borrowers were paying 1% on their mortgage for that seven-year period and with base rate now at 0.25%, they would be paying just 0.75%.

The other main type of variable rate mortgage is a discount mortgage. Here, you pay the lenders SVR, minus a fixed amount that is discounted. So, if the lenders’ SVR is 4.74% and the discount mortgage has a 1.7% discount, you’ll pay 3.04%.

Discount mortgages can have variable rates over the course of the product deal because they can be ‘stepped’, so, you might pay one rate for 12 months and a different one the following year.

Some variable rate mortgage deals have a ‘collar’, i.e. a rate at which they cannot fall below or are capped at a level they can’t go above.

Standard variable rate (SVR) mortgages

Every lender has their standard variable rate which can change but doesn’t do so very often and is generally uncompetitive. If you are on an SVR, try and remortgage to a better deal.

Try and get on a better deal if you can but for some borrowers who have had a change in circumstances, such as losing a job, starting in self-employment or suffering from negative equity, languishing on an SVR is their only option until circumstances change and they can qualify and be accepted for a better deal.

SVR’s are set at whatever level the lender wants and are not linked to the Bank of England base rate.

If you are on an SVR mortgage, one advantage is that you are free to leave at any time if you can agree another mortgage.

Capped rate mortgages

With a capped rate mortgage your rate changes when the lenders’ SVR changes, but at a level that is capped so it can’t rise above an agreed level. You need to check what the maximum level of the cap rate means in terms of how high your monthly repayments could rise to and ensure you can make the payments if it goes up to the maximum level. This gives borrowers security that there monthly repayments will not rise above the amount set by the cap.

However, be aware that the cap can be set quite high and you may be able to qualify for a better deal elsewhere.

Interest-only mortgages

Interest-only mortgages are not as common for new borrowers as they were before the 2008 financial crisis. New rules after the mortgage market review and concerns over irresponsible lending means they are rarely issued in the current mortgage market, but many borrowers have remained on them.

With an interest-only mortgage the borrower does not repay the capital, just the interest. Borrowers need to have a separate savings or investment product in place to try and repay the capital balance at the end of the mortgage term.

It means you have cheaper repayments but you are not repaying any of the capital you have originally borrowed.

Offset mortgages

Offset mortgages are ones where you combine your mortgage repayments with a savings account to save money on the mortgage interest repayments. Interest rates for offset mortgages are usually fairly competitive.

An offset mortgage uses savings from a linked account to reduce the amount you pay interest on, on your mortgage. In a low interest environment, which in the UK has existed since 2009, this can be beneficial because you are effectively getting your mortgage interest rate on your eligible savings rather than the savings rate. Most people pay more in mortgage interest payments than they receive in savings interest, so it is often financially beneficial to do this. It is also flexible in that you still have access to your savings if you need them for another reason.

Joint mortgages

If you are living with your partner or married you may opt for a joint mortgage which means taking out a mortgage in both names. Some lenders will allow up to four people to be on a joint mortgage.

Everyone named on the mortgage is responsible for the repayments and you need to decide about how the equity in the property is shared.

Joint mortgages are available to couples, married or not, civil partners and friends or other family members who you intend to live with.

Cashback mortgages

When you are moving home getting some funds back to help pay with possible costs or home improvements can be appealing. There are mortgages that will give you some money back. However, the rates and overall repayment costs mean the overall cost can be high, so ensure you work out the total cost before selecting a deal.

Guarantor mortgages

A guarantor mortgage is when a parent or close family member guarantees the mortgage debt. They are useful mortgages for first-time buyers struggling to take their first step on the property ladder.

By acting as a guarantor the parent agrees to cover the mortgage repayments if the buyer misses a payment. Often the family member guaranteeing the mortgage uses their own property as collateral against the property, although some lenders insist on receiving a lump cash sum to be deposited in a savings account earning interest and to be used as insurance.

In a worst case scenario, the guarantor could lose their savings or property but if no payments are missed it won’t cost them anything.

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