Understanding the different types of mortgages
Selecting a mortgage is a difficult decision that you’ll need to think about carefully. While you can choose to receive advice from either a lender or adviser, make sure you are up to speed with the different types of mortgage so you feel fully prepared for the conversation.
You could think of fixed rate mortgages as being similar to a price freeze. This type of mortgage guarantees that your interest rate, and therefore your monthly payments, remain the same for a specified period of time – and don’t change until an agreed date. This can be anything from 2 to 3 years, up to 10 years or even more.
Fixed mortgages are great for the certainty and peace of mind that comes with knowing exactly what you have to pay every month during the fixed period.
The interest rates are usually higher than other mortgage types. Also, if interest rates fall during the fixed period, you won’t see your monthly payments drop with them as you would with a tracker mortgage (see below).
When the fixed period ends it is most likely that you’ll automatically be transferred onto the lender’s Standard Variable Rate (SVR, see below). This is usually a higher rate of interest than the fixed one you were on. As your deal will have ended, you’ll be free to move onto a new mortgage, so don’t forget to plan ahead well before your fixed period ends.
A tracker mortgage has an interest rate that typically follows the Bank of England base rate, plus a set margin. So the mortgage interest rate can vary throughout the tracker period, depending on movements in the base rate. The base rate is the official interest rate that the Bank of England charges banks for lending them money – something which it reviews on a regular basis.
So if your mortgage is set at 1% above the Bank of England base rate, and the base rate then increases or decreases, your tracker rate will move to the revised rate plus 1%.
Trackers are typically for 2 to 5 years, but can be for the term of the mortgage.
Lenders can’t influence what your mortgage rate will be. Your interest rate is typically linked to the Bank of England base rate. So you’ll know for sure how much your mortgage rate will go up or down as the base rate changes.
Your mortgage payments can change at any time and so you don’t have the certainty that you would with a fixed rate mortgage. If the base rate rises, your payments will go up.
A Standard Variable Rate mortgage has an interest rate that is set by your lender and can move up or down at their discretion. Mortgages that have an initial period at a fixed, tracker or discount rate will typically switch to a lender’s SVR at the end of this period.
You’re not tied in for a set period, so you’ll have the flexibility to move onto a different deal without incurring any Early Repayment Charges. The same goes if you have reverted to the SVR after your deal has ended.
As the rate you get with an SVR can move up or down at the lender’s discretion, your monthly payments can also increase or decrease. SVRs do not track rates such as the Bank of England’s base rate, therefore if this changes, there may not be a corresponding change in your monthly payments.
Lenders will tell you in advance about changes in your rate and when they will occur.
As the name suggests, the rate you get is a discount on the lender’s Standard Variable Rate for a set period of time. The discounted rate will move up and down in line with the lender’s SVR.
How you repay your mortgage is another big decision. Would you like to pay off the amount you borrowed together with the interest? Or just the interest on the loan?
Repayment mortgages are the most common type. The way they work is that the payments you make every month gradually pay off the original amount you borrowed (the capital), as well as the interest on the loan.
At the end of the term, provided you have kept up with your payments, your mortgage will be repaid in full. You also get the peace of mind that you will own your property outright.
Monthly repayments will be higher than with an interest-only mortgage – and in the beginning, you’re mostly paying off interest on your loan. So if you move home early on, you could find that you’ve not paid off much of what you borrowed.
The monthly payments you make throughout the term of your mortgage only pay off the interest – not the actual loan itself. This means that at the end of the term you will still owe the original amount that you borrowed. Mortgage advisers or lenders will not recommend these mortgages for everyone.
In order to be considered for an interest-only mortgage, you’ll need to prove that you have the ability to repay the loan at the end of the term.
Your monthly payments will be much lower than they would be with a repayment mortgage.
You won’t be paying off the original loan amount that you borrowed and will need to have a plan to build up the money to pay it off. Some ways include setting up a pension plan, using savings or investments, buying shares, bonds or a buy-to-let property.
The mortgage term is the period over which you choose to repay the mortgage.
In making this decision, keep in mind that lenders will not typically allow you to choose a mortgage term that would extend beyond the date you expect to retire.
For repayment mortgages:
Your mortgage term will have a big impact on your monthly payments. Mortgages tend to span 25 years but you can choose to set a shorter term to pay off the loan sooner, which will increase your monthly repayments, or a longer term to reduce them.
If you’re keen to settle the loan as quickly as possible, you may want to consider a mortgage which gives you the flexibility of making overpayments, rather than committing yourself to a shorter repayment term. Although make sure you check whether any overpayment fees apply.
Fees and charges
There are several fees and charges that you need to be aware of when it comes to getting a mortgage. Here are the most common ones to familiarise yourself with. Be sure to confirm with your mortgage adviser or lender what fees you will be charged and whether or not they are refundable.
This fee is sometimes known as application or reservation fee. You pay this at the point of applying for a mortgage in order to reserve, or book, the mortgage funds until your application goes through.
A booking fee is typically between £99-£250, but some lenders don’t charge at all or include it as part of the arrangement fee. This isn’t usually refundable and you will normally pay it upfront – although some lenders will let you add this to the loan amount.
This is sometimes known as product or completion fee. It helps to think of a mortgage as a product and this is the cost to buy it. You can expect to pay anything from very little or nothing, to more than £2,000. If your mortgage application is declined or you decide not to proceed, this fee may not get refunded.
If you’d rather not pay this upfront, you could choose to add the fee to your mortgage loan instead. But keep in mind that in the long run it’s not cost-effective since it not only increases what you owe – it also means your interest and monthly payments will be more expensive, and you will be paying interest on the fee.
The lender charges this to undertake a mortgage valuation, which will determine whether the property you’re interested in buying is one that they’re comfortable lending against.
This will typically cost between £150 and £1500, depending on the value of the property. You will also have to pay this upfront, when you make your application. Some lenders might waive this fee on certain mortgage deals.
While this isn’t an upfront cost, knowing what the ERC is might influence which mortgage deal you go for. An ERC is payable to the lender if you repay some or all of the mortgage early, i.e. during the set deal period of your mortgage.
For example, you might have a mortgage with a rate that is fixed for 3 years. If you would like to pay more than the agreed monthly amount within this fixed period (to help pay off the mortgage a little faster), an ERC might be charged. How much and whether you have to pay this charge, will depend on the mortgage you’ve chosen and the ERC rules for it.
Each deal and lender will have different rules, so be sure to check your Key Facts Illustration document to familiarise yourself with the rules and costs. Typically the charges range from 1–5% of the amount you decide to repay early.
There are some cases where you can make an overpayment without paying extra fees. Some mortgage deals allow you to pay more than the agreed monthly amount. This is called a ‘product overpayment limit’. But keep in mind, lenders will have a set limit beyond which you will have to pay a fee. Again, check your product’s Key Facts Illustration for more details.
Understanding loan-to-value (LTV) and APR
Which mortgage deal you can go for will also depend on the loan-to-value, or LTV. The LTV is all about how much you want to borrow in relation to the value of your property.
Here’s an example: a property is worth £250,000 and your deposit is £25,000. Your deposit is 10% of the property’s value and therefore your mortgage would be 90% of the property’s value. Knowing this, you can look at mortgage deals for LTVs of 90% or above.
LTV is important because certain deals are only available for specific LTVs, and typically the lower the LTV, the better the interest rate – the reason why having as big a deposit as possible is so important. So calculate what your LTV is, based on the approximate price of the property you’re interested in and the size of the loan amount. Then you’ll know what deals will be available to you.
The Annual Percentage Rate that the lender gives alongside the interest rate is used to help you compare the cost of borrowing money. Since the APR includes any upfront fees charged by the lender spread over the period for which you are borrowing the money, it’s a way to compare different mortgages.
Be aware though, that the APR will assume you stay with the same lender after any deal period ends, and switch to their SVR (see above). In reality, you will be able to switch to a new deal at this point, so may be able to pay a lower rate than the APR estimate, however, there may be a cost to do this.
The Key Facts Illustration
All the information about the mortgage you’ve been recommended by your mortgage adviser or lender will be included in a handy document known as a Key Facts Illustration (KFI).
The KFI will outline in detail all the key elements of the mortgage, such as the overall cost of the mortgage (including interest, over the full mortgage term), your monthly repayments, the fees you would have to pay upfront to get the mortgage, the initial rate you get on your chosen deal, the Standard Variable Rate and the overall interest rate over the loan period for comparison (APR – see more on this above).
It will also tell you what happens if interest rates rise and how this would affect your repayments, any Early Repayment Charges that might apply, together with any other features and restrictions attached to your mortgage, such as the ability to overpay or underpay. It also tells you what happens if you don’t want the mortgage anymore.