Types of Mortgages Demystified
Types of Mortgages
There are two main types of mortgage that basically refer to the way you repay the amount you've borrowed (the ‘capital’). Repayment Mortgages and Interest Only Mortgages. There are then a number of interest rate options that also determine the type of mortgage you have.
Repayment Mortgages (also called a capital and interest loan)
With a Repayment Mortgage your monthly payments gradually pay off the amount you owe (capital) as well as paying the interest charged on the loan. Provided you make all the agreed payments, the loan will be fully paid off by the end of the mortgage term. Sorted!
Interest-only mortgage (also called ISA, pension or endowment mortgages)
With an Interest Only Mortgage your monthly payments cover only the interest charged on the loan amount. The payments do not pay off any of the capital. You'll need to arrange to pay separately into a savings or investment scheme to build up a lump sum to pay off the mortgage at the end of the term. It's your responsibility to make sure you have enough money to repay the mortgage at the end of the term, otherwise you could lose your home. Using an interest-only mortgage keeps your monthly payments down.
Repaying an Interest Only Mortgage
If you choose an interest-only mortgage, make sure you know from the outset how you intend eventually to pay off the loan. You don't have to arrange this through your lender. Your main options are to:
Save regularly
You could make payments into a savings or investment scheme each month to build up a lump sum to pay off the loan when the mortgage term ends (or sooner if you can afford it).
Convert to a repayment mortgage later
This might be a suitable option if, say, your earnings are low now but are expected to be much higher in future, for example, when you've finished training or gained professional qualifications. Using an interest-only mortgage keeps your monthly payments down until you can afford the higher monthly payments of a repayment mortgage. Because you're putting off repaying the capital you will end up paying more interest and more in total for your mortgage over the term.
Use a lump sum from somewhere else
For example an inheritance, or selling something such as another property or a business. Risky strategy.
Sell the mortgaged property to pay off the loan
This is only really suitable if you won't need to live in the property - for example, if it is a buy-to-let property or a second home, or you are buying something smaller or cheaper.
Types of Interest Rate Options
When you have chosen the right mortgage for you, whether it be a repayment or an interest only mortgage, you will need to consider the 5 main mortgage rate options available:
When deciding on a Mortgage Interest Rate Option, you need to ask yourself a couple of questions:
Firstly do you want the security of a fixed rate mortgage or whether you want a variable rate which will take advantage of any falls in interest rates?
Secondly you need to ask yourself whether you want to choose a short or long term mortgage deal. What looks like a more expensive mortgage today may end up being more suitable for you in the longer term. Make sure you know what happens after any special deal ends and act in time to take advantage of the newest deals (and avoid reverting to the default and expensive standard variable mortgage).
Fixed Rate Mortgage
With a fixed rate mortgage the amount you repay the lender each month can be at a fixed interest rate for a specified period of time, regardless of changes to interest rate in the market place. It is common for lenders to offer rates fixed for a period of 2 to 5 years, but shorter and longer periods can be found in the market. At the end of the fixed rate (or ‘benefit’) period the rate will normally convert to the lenders Standard Variable Rate (SVR).
It is normal for lenders to charge up-front fees in the form of booking and/or arrangement fees. In addition lenders frequently apply an Early Repayment Charge (ERC) for fixed rate mortgages. This acts as a ‘lock-in’ making an often heavy charge for borrowers paying off their mortgage early. Watch out, as the ERC can sometimes last longer than the fixed rate period e.g. a 3 year fixed rate with a 5 year ERC.
Capped Rate Mortgage
A capped rate mortgage is very similar to a fixed rate mortgage except that if the variable rate drops below the capped rate, the borrower will make payments based on the lower variable rate. However, should rates increase the payments will be ‘capped’ and will not rise over the capped rate. So as a rough ‘rule of thumb’ a capped rate is better to have than a fixed rate if all other factors are equal. Again, as with fixed rates, up-front charges and ‘lock-ins’ are common.
Discounted Rate Mortgage
The Lender offers a discount on the Standard Variable Rate (SVR) for a specific period of time. For example, the variable rate may be 5% with a discount of 1.5%. The initial pay rate would therefore be 3.5%. If the variable rate rose to say, 6%, then the rate payable would rise to 4.5%. As the discount is linked to the standard variable rate, the borrower’s payments will increase, if rates rise - so there is no certainty in budgeting. However, should rates decrease, the borrower will benefit from lower payments.
It is still possible to have up-front charges for discounted products and an Early Repayment Charge is common.
With discount mortgages borrowers need to watch out for ‘payment shock’. Some short term discount products offer a ‘deep discount’ e.g. 4% off for 1 year. In such circumstances the borrower will be facing a significant increase in their monthly mortgage payment at the end of the discount benefit period.
Variable Rate Mortgage
Borrowers paying the Standard Variable Rate will have their payments increase or decrease as the lender adjusts the rate in accordance with market conditions.
As their name suggests the rates of tracker mortgages change to follow ‘track’ changes in the base rate to which they are linked. So if the base rate increases by 1%, the pay rate will increase accordingly. Also if the base rate is reduced, borrowers will benefit from a lower pay rate.
This is a variable rate that is linked to the movement of a prevailing rate such as The Bank of England Base Rate or London Interbank Offered Rate (LIBOR). The pay rate will be a set percentage amount above the relevant base rate for a specified period of time. For example if the tracker mortgage is set at 1% above The Bank of England Base Rate for 5 years and the base rate is currently 4.75%, the pay rate will work out at 5.75%.
Shop Around
It's important that once you've identified the type of mortgage that best suits your needs, you shop around. There can be a huge difference between mortgage deals so make sure you get the best value deal.
Remember to add the extras. A 2 year discount at a lower rate could have a very high set up charge so that in the end may costs you more - this is where a good financial adviser will help you.
Useful Links
The government's money made clear website has some excellent mortgage advice.
The mortgage advice bureau website has some useful mortgage information
www.mortgages.co.uk is another useful mortgage information site
www.fool.co.uk is a great mortgage comparison site
As is www.moneysupermarket.com
www.unbiased.co.uk is the independent financial advisers (IFA) website and is packed full of information and how to find an IFA near you
Post new comment