There are many different types of mortgages on the market, which is terrific - it means you have options.
However, choosing between them is often quite complicated. Each type of mortgage comes with its own features, some more suitable for certain lifestyles and circumstances than others. How do you know what suits you? Do you want an interest-only or repayment mortgage? Should you go for a Standard Variable rate (SVR) or fixed rate? Do you need any special features? It’s all rather confusing and can take a while to fully understand.
You’re often bombarded with many different mortgage products – discounted, fixed, tracker, flexible/offset, including those aimed at specific sections of the market, e.g. first-time buyers, home movers, remortgagors, and buy-to-let – which can make the process seem overly complicated.
But you don’t need to be an expert right away; you just need somewhere to start from.
We’ll help you answer the following questions:
- Do you want a repayment or interest-only mortgage?
- What type of interest rate option would suit you – tracker, discounted, fixed?
- What other special features might appeal to/suit you?
Repayment or Interest-Only?
Before you settle on what type of mortgage product you want, you need to decide how you’re going to repay the mortgage you’re about to take out. In other words, you need to choose between a repayment or interest-only mortgage. Essentially, you decide whether you want to make monthly repayments comprising both interest and capital, or whether you want to only pay the interest on the money you’ve borrowed and repay the loan later by lump sum payments or possibly even by selling the property.
With a repayment mortgage, your monthly repayments cover both capital and interest on the loan. No other repayment vehicle is needed.
A repayment mortgage is simple, straightforward and easy to understand. You don’t have to worry about paying it all back in one go and it avoids the risk of investing in the stock market for your repayment vehicle. As long as you maintain your full mortgage payments for the full term, your mortgage is guaranteed to be cleared at the end.
You can’t benefit from a potential rising investment which is affected by the stock market, like a pension or ISA. Also, when remortgaging, those who previously chose a repayment mortgage sometimes select another, long term repayment mortgage to keep the initial monthly costs down. This means that the overall total period of your mortgage could increase over time, which will increase your total mortgage cost.
With an interest-only mortgage, your monthly payments to the lender only cover the interest on the loan; they don't repay any of the capital. The full amount of the loan remains outstanding and has to be cleared at the end of the term when the lender asks for the money back. You can pay it back early, subject to the terms and conditions applicable at the time.
To check that you should be in a position to make this final payment, the lender will ask what your repayment plans are - ISA, investment fund, pension or equity in any other properties you may own like a buy-to-let.
You can choose from a variety of appropriate investment vehicles, some of which can have tax advantages. Furthermore, should you move or remortgage, your investment vehicle can usually be reallocated to the new mortgage. We always recommend speaking to an investment adviser if this is a route you want to consider.
Unlike a repayment mortgage, your total amount of debt doesn’t reduce over time. There’s also no guarantee that your chosen investment vehicle will grow sufficiently to repay your loan, although you can usually top up your contributions to investments as you go along if a shortfall looks likely. You can also approach your lender to see if you can convert some or all of your mortgage to repayment to cover any investment shortfalls.
It’s also important to note that lenders who permit interest-only mortgages will only do so up to certain loan-to-value (LTV) limits - currently 75% LTV maximum).
Interest Rate Options
Once you've decided whether to make monthly payments on the capital or not, you need to turn your mind to interest rate options. There are several different types of interest rate products that lenders offer. Each has its own advantages and disadvantages, but these are subjective. What you see as a disadvantage may be beneficial to someone else. The mortgage type you choose ultimately depends on whether it fits your current and future needs.
SVR (Standard Variable Rate)
The simplest - and original - form of interest rate product is one which sets its interest rate according to the lender's standard variable rate, or SVR. The SVR is the background rate that the lender charges interest at. They set it themselves and if the Bank of England increases the base rate then lenders are likely to increase their SVRs in line. It’s important to note that because the lender can set their SVR at whatever level they like, they can also increase or decrease it by whatever margin they choose, even if it’s not necessarily in direct line with any change from the Bank of England.
Most borrowers are automatically transferred to their lender's SVR once their initial, often promotional or introductory rate period ends.
There are usually no early repayment charges.
The unpredictability of interest rate movements makes it hard to plan your finances and the costs of your mortgage may rise rapidly if interest rates go up. Also, the actual SVR rates themselves tend to be significantly higher than any introductory rates.
A discount rate mortgage offers a reduction or discount of a set amount off the lender's standard variable rate. If the SVR changes, the rate you pay will fluctuate in line with that change but at the same level of discount, e.g. 0.5% below SVR.
Usually, a greater discount means a shorter period of discount. After the reduced rate ends, the loan normally reverts to the lender's SVR. At which point your payments will increase as the discount is removed.
You can make a significant saving in comparison with the SVR, as you’re charged interest at a discounted rate.
Discount mortgages often have significant early repayment charges during the discounted period. These can make it expensive for you to remortgage to another rate or lender before the end of the discount.
A fixed rate is a set rate of interest for a set period of time. Once that period ends, the rate reverts to the lender’s SVR. Fixed rates are available for many different lengths of time, e.g. 2, 3, 5, 10 years and sometimes longer.
Fixed rates tend to be very competitive, due to how popular they usually are. Lenders have to compete for your business so they tend to offer as low a range of rates as they can, which ultimately gives you better options to choose from.
As a fixed rate won’t change during the specified period, you know exactly how much your payments will be for that time - even if the Bank of England changes its base rate. This could help you budget more effectively.
Fixed rate mortgages often have an early repayment charge. Furthermore, if the base rate drops your fixed rate won’t; this may prove more expensive than a discount or tracker rate which would reduce.
A tracker rate moves automatically in line with the Bank of England’s base rate by a set margin that usually remains the same for the initial product period. It’s unaffeted by changes in your lender’s SVR.
Tracker rates often track the Bank of England’s base rate by a certain percentage, e.g. the base rate plus 0.75% for 2 years or even the full term of the mortgage.
Many tracker products also offer flexible terms and are useful if you want to benefit from falling interest rates. However, it’s important that you’re certain you could afford any increases should the base rate rise.
A tracker rate allows you to immediately benefit from any reduction in the bank base rate. They’re also sometimes a bit cheaper than fixed rates.
If the base rate rises, so will your tracker rate - and by the same margin of increase. Tracker rates lack the security of the fixed or capped rate mortgages.
As well as being one of the above interest rate types, some mortgages products include other features.
There was once a specific type of mortgage product called a cashback mortgage. This was where a lender offered a significant percentage of the loan amount as cash paid on completion. These mortgages were usually on SVR for the first few years - at least. But now, cashback is often a lot smaller in size and is an added benefit of other mortgage types, liked a fixed rate or tracker mortgage. When you take out a mortgage with cashback, you receive an upfront lump sum. The lump sum used to be a fixed percentage of your total mortgage, but now it’s a set lump sum that’s usually between £250 - £1,000, depending on the lender and deal on offer. Modern cashback benefits are generally to pay for things like conveyancing fees or surveys costs.
A lender that covers the conveyancing fees will choose a solicitor for you, whereas those that offer cashback give you the freedom to choose whichever solicitor you like. Furthermore, as you’re paying you may have more control over that side of the transaction.
You may miss out on having part of the process arranged for you, like conveyancing, however this needn’t be a problem if you use a mortgage broker. We can find you a solicitor or liaise with one you already have in mind.
A droplock mortgage is a discount or tracker mortgage that comes with the option to switch to a fixed rate with the same lender at any point during the initial period, without paying any early repayment charges.
It allows you to benefit from base rates when they're low, with the option to switch to the protection of a fixed rate should interest rates look set to significantly rise.
It contains a similar level of risk as a discount or tracker rate mortgage and it’s up to you to make the switch to a fixed rate, which could be higher – the lender will not suggest when to make that switch.
Offset mortgages involve linking your mortgage account to a savings or current account. This allows you to offset the - hopefully - positive balance of your savings against your outstanding mortgage balance. Your interest is then calculated daily on the net balance between the 2 accounts.
Depending on the set up, your monthly payments can either remain the same while the term reduces, or you can keep the term the same so your monthly payments reduce. They’re highly useful to people with significant savings, as well as those who can afford overpayments. This is especially true for higher rate taxpayers. Not all lenders have the facilities to offer both offsetting methods so you should be clear about what you need before you apply.
The more money you can put into the offset savings account, the less you’ll pay in mortgage interest. You can also withdraw money out of your savings account with ease at any time, for any reason.
Offset mortgages are more complicated than traditional mortgages and the rates can sometimes be a little higher as a result.
Repayment Methods for Interest-Only Mortgages
When you choose an interest-only mortgage, you need to arrange a repayment method to pay back the capital at the end of the loan period. You don’t need to arrange a repayment method for a repayment mortgage, as you pay back a bit of capital each month alongside any interest charged.
There are numerous repayment methods for interest-only mortgages available, including a pension, ISA or equity in property.
You may have also heard of using endowments. These were a very popular repayment option some years ago, but they’re not really anymore. Nonetheless, we’ve given a bit of background about these as some people are still using the ones they chose way back when.
These are hardly used at all nowadays, but some people may have one from the past that they’re still using as part of their repayment strategy. With an endowment mortgage, you make your monthly repayments of interest to the lender alongside contributions to an insurance company to fund a savings plan. This savings plan aims to generate sufficient funds to pay off the capital at the end of your agreed mortgage term.
The savings plan can be “with profits”, unit-linked”, or a combination.
"With profits" policies pay 2 types of bonuses. An annual "reversionary" bonus that’s usually paid into the savings plan each year and, once awarded, is normally guaranteed - provided the policy is still active on the maturity date - and a "terminal" bonus that’s awarded on the policy maturity date. Its size will depend on the performance of the fund over the lifetime of the policy.
With "unit-linked policies", the value is driven by the underlying value of the investments when the policy reaches maturity.
If you pass away before the end of the term, the life insurance aspect of any endowment policy is used to clear the loan. The level of that cover should be reviewed regularly as people’s mortgage balances do not remain the same over a long period of time.
One benefit of an endowment repayment vehicle is that you keep the policy if you move house or change mortgage provider. Endowments can include life and critical illness cover that can be cheaper than buying such cover separately.
There’s no guarantee that your underlying investments will perform well. You may wind up reviewing the monthly payments to your endowment policy and/or the actual repayment basis of your mortgage to ensure that the mortgage loan can still be repaid in full at the end of the agreed term.
They’re not really used anymore except by the people who chose them in the past and are still using them as part of their repayment strategy - so you don’t need to worry about them if you’re looking to take out a new interest-only mortgage.
With a pension repayment vehicle, you make your monthly repayments of interest to the lender and contributions to a pension. This pension should provide a tax-free lump sum as well as a taxed regular income at retirement. You use most, if not all, of the tax-free lump sum to clear your mortgage loan at that date.
Pension contributions qualify for tax relief of up to 40% - for a higher rate taxpayer. This will boost the value of every pound you contribute to your pension.
Using your tax-free lump sum as a mortgage repayment vehicle may leave you with inadequate income in retirement. Furthermore, the lump sum is only payable on retirement, so your loan term could be over 25 years - depending on how old you are and when you plan on retiring.
The biggest problem with pension repayment vehicles is that poor performance could adversely affect the amount of the tax-free lump sum, leaving you with insufficient funds available to repay the loan at the end of the agreed term.
When you use an ISA as a repayment vehicle, you make your monthly repayments of interest to the lender and you make contributions to an Individual Savings Account (ISA). ISA mortgages use stock market-based investments for tax-free growth.
There are 2 main types of ISA: "Cash" and "Stocks and Shares". There are different rules over contribution levels and a range of investments available in each.
A well-performing ISA could potentially give you the means to pay off your mortgage early.
A poorly performing stock market could reduce the value of your investment and leave you with a shortfall come maturity that you would have to somehow fund.
Equity in Property
Nowadays, lenders will consider the equity in other properties you may own as a means to cover some, or all of an interest-only mortgage. Some lenders will even consider the equity in your home as sufficient to simply allow “downsizing” as a repayment strategy. They have pretty strict rules surrounding this so you should talk to your lender or broker before suggesting equity in property as a repayment strategy.
Even More Mortgage Types Explained
With so many different types of mortgages in the marketplace, you could be forgiven for not knowing all the types on offer. There really are a lot - but each one boils down to one of the above types.
It’s not made any easier by the fact there are different names for mortgages that have the same base elements – e.g. an interest-only fixed rate mortgage – and that some products are only available at certain rates to selected types of borrowers – e.g. first-time buyers, buy to let, or existing borrowers.
First-time buyer mortgages or buy to let mortgages, are still either repayment or interest-only, fixed rate or tracker rate, etc. Our advisers guide you through the terms and types, ultimately helping you figure out which deal is best. Call us on 03304 332 927or make an enquiry.
John Charcol is not authorised to offer investment advice. We recommend you seek professional advice about these topics if you believe they may affect or be of interest to you.