There are several key factors to consider when picking the right mortgage – the interest rate you pay, the number of years the mortgage will run, and how you plan to pay it off.
But mortgage products are rarely what they seem. As a rule, the small print will be packed with dirty tricks designed to mislead and obfuscate. Each ‘product’ comes loaded with sweeteners and in many cases nasty penalties to catch out the unwary. Below we explore each factor in turn.
Interest rate options
The amount you pay in interest is largely influenced by the Bank of England’s decision each month whether to cut, raise or hold UK interest rates.
Lower rates are often used to try to boost spending in a recession, and higher rates to rein in consumer spending and inflationary price rises in a boom.
The decision is more difficult when both factors are present – when prices are rising, but the economy’s simultaneously stalling, as happened in the 1970s when economic stagnation combined with inflation to produce the bastard offspring dubbed ‘stagflation’.
More recently the credit crunch raised the price at which banks lend money to each other on international markets, causing mortgage rates to rise.
Predicting future rates is a tough call, since unexpected events a million miles away can affect sentiment – a run on the yen, a Beijing stock market shock, a tsunami, bird flu or terror attacks.
In 1992 interest rates rocketed as high as 15 per cent, but have since plumbed the depths of less than 3 per cent.
On a £150,000 mortgage that’s the difference between paying £1,875 a month and £375 (interest only) – which could seriously affect your amount of spare beer money. So unless you possess a reliable crystal ball, it might be worth opting for the security of a fixed mortgage rate.
Each lender will have a standard variable rate (SVR) mortgage – which is typically about 1.5 or 2 per cent above the Bank of England rate – from which all their other deals are calculated.
A discounted mortgage might, for example, be 1 per cent lower than the lender’s SVR for a couple of years. Sometimes lenders use other names for their key variable rate, such as ‘base mortgage rate’ (BMR).
Picking a variable rate lets you ride the market waves, cashing in on rate cuts but also having to endure any increases.
But this is the bog-standard mortgage and, being relatively uncompetitive, is normally best avoided. It is often better to opt for a special fixed or discounted deal.
When these come to an end, they automatically revert to the dearer SVR, bumping up your monthly mortgage payments until you get round to arranging a fresh deal.
A fixed rate mortgage does exactly what it says on the tin. Locking your rate at an agreed level means your payments are firmly fixed, guaranteed to stay the same regardless of global stock market crashes, rocketing base rates or hell freezing over.
With predictable mortgage payments, budgeting is obviously a lot easier and there are no nasty shocks. The downside of being protected from rate increases is, of course, the possibility of missing out on any potential rate cuts.
Fixed rates tend to run for two, three or five years, although longer-term deals can be found.
The cheapest rates tend to be for two-year fixed rates, because there’s less risk for the lender than for the equivalent five-year option.
During this period you have to stick with the agreed deal or pay a penalty, which isn’t an unreasonable stipulation. So if there’s a chance that you might need to move in the short term, think twice before fixing.
The other thing to avoid is any overhanging ‘tie-in’ period that continues after the end of the fix.
An interesting variation on this theme is ‘stepped fixed rates’, which are fixed for an initial period but then rise over time at set intervals, so you know exactly what your repayments will be.
Usually some of the cheapest deals are available as discounted rates, pegged a per cent or so below the lender’s SVR.
Discounted rate deals are usually offered over a period of two or three years, and are cheaper for a shorter term. But discount rates move up and down in relation to the standard variable rate, like a basket under a hot air balloon. So you could be in for a bumpy ride (albeit at a discount).
Capped mortgages were invented to overcome all the bad habits of discounted and variable rates. They can still go up, but only by a limited amount, before hitting a maximum ceiling or ‘cap’.
This means you know the worst scenario in advance.
Here you get the best of both worlds, reaping the benefit if rates fall while the cap protects you from the worst effects of a rise. Capped rate deals are usually available over three, five or ten years.
The drawback is that interest rates tend to be higher than for fixed rate deals and not so many lenders offer them, so there’s less choice.
And because even the experts find it impossible to predict long-term interest rates, it makes sense not to tie yourself into one deal for more than about five years at a time.
Tracker mortgages follow movements in the Bank of England base rate at a set margin, say 1 per cent above it.
Trackers offer a significantly better deal than the lender’s standard variable rate, and most don’t carry penalties should you want to switch to another deal. They are therefore attractive if you want the flexibility to change your mortgage quickly.
Unlike discounted rates, which are linked to the lender’s SVR, your lender can’t suddenly decide to boost their profits by widening the margin. The drawback is that trackers are variable and follow the upswings and downturns of Bank of England base rates, hence a lot less certainty.
And many have ‘collars’ that set a floor to how low they will go regardless of how far the base rate drops. Some ‘discounted base rate trackers’ offer large initial discounts for the first 6 or 12 months, which allows the lender to publicise the deal with headlines quoting a mouth-wateringly low introductory rate.
Offset mortgages/current account mortgages (CAMs)
If your mortgage is with same bank as your savings or current account, with an ‘offset mortgage’ the two can work together to reduce your payments.
Although your savings are kept in a separate account, they’re offset against the total mortgage debt. So suppose your mortgage is £100,000 but you’ve got savings of £4,000 and another £1,000 sitting in your current account, they’ll only charge you interest on £95,000.
This can be worth considering because banks normally pay a miniscule interest on current accounts and not a great deal more on savings. So in effect they’re paying you a far higher rate equivalent to what they charge at their mortgage rate, plus you won’t get taxed on interest earned. You can still spend your cash in the normal way.
There is even a ‘friends and family’ version where you can persuade others to open accounts at the same bank, and their savings help reduce your mortgage interest payments.
A current account mortgage is similar to an offset, except that you keep all your money (ie your current account, savings and even personal loans and credit cards) lumped together in one account.
Which means that when you get a bank statement you may appear to be alarmingly overdrawn to the tune of hundreds of thousands of pounds – roughly the amount of your mortgage!
The attraction, however, is that the small change sitting idly in your current account is now gainfully employed eating away at your debt. So when you get paid each month, until you spend your money it will beaver away helping reduce your mortgage.
But like offset mortgages, the downside is that interest rates are often at the lender’s SVR and are less competitive than for fixed or discounted deals. Consequently you need to have several thousand pounds in savings to make it worth opting for one of these.
Portability and flexibility
Most of the above types of mortgage should also be available as ‘portable’ loans, allowing you to move home and take your mortgage with you to secure on the new house. This saves having to pay a redemption penalty if you’re tied in for a number of years.
Some mortgages allow you to overpay when you feel flush with spare cash but then miss a payment or two when times are hard. By overpaying for a while you should be able to build up a reserve, that makes it possible to underpay when the need arises. Some flexible mortgages allow you to take a ‘payment holiday’, although this inevitably means your mortgage will take longer to pay off.
If your main goal is to pay off your mortgage as quickly as possible, and save shed-loads of money in the long term, many standard variable mortgages allow you to pay up to ten per cent extra per year. A flexible mortgage is good for the self-employed or where your income fluctuates.
Hey big lenders
The largest UK mortgage lenders include:
- Barclays – Woolwich
- HSBC / First Direct
- Lloyds (including Halifax / HBOS and C&G)
- Royal Bank of Scotland – NatWest
- Santander Group (Abbey / Alliance & Leicester / B&B)
Regulation of mortgage providers is split between the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA).
Lenders are legally required to present customers with a ‘key facts’ document containing simple, user-friendly information about their mortgage offer.
This should set out the total cost of the loan, including any up-front fees, not just the headline interest rate. New customers have to sign a written confirmation that they have been given the key facts document before the mortgage can proceed.
The mortgage term
Strange word, ‘mortgage’. Scholars may recognise its French origin, which literally translates as ‘death pledge’ – in other words a ‘pay till you drop’ life sentence, or the proverbial millstone round your neck.
Traditionally mortgages were taken out for 25 years and you stuck with the same lender through thick and thin. To be sure of repaying it by the end, you would normally pay a bit extra each month to slowly eat away at the mountain of debt.
Today, however, we are all encouraged to be ‘rate tarts’ – in other words it can pay to shop around, switching lenders every few years to get the best deal. Otherwise your existing lender will reward your loyalty by lumbering you with an expensive standard variable rate loan.
It’s still common for home buyers to take out a mortgage for a period of 25 years, although it’s a bit academic now that everyone switches lenders every two or three years to get a better deal.
For first-time buyers, the trend is towards longer terms of 30 years or more, because spreading it further into the future can make monthly repayments a bit lower. The downside of a longer term, of course, is that the total cost over all those years will be much higher.
In reality, over the last 50 years house price inflation has dramatically boosted the value of our homes in relation to the mortgages secured on them. So what is now a sizeable loan could be peanuts in quarter of a century’s time.
On the other hand, when prices rise there’s a ‘feel-good factor’ that makes it very tempting to keep increasing the size of the mortgage, taking money out to pay for extensions, cars or holidays, so it doesn’t actually shrink much over time.
Which means there’s still the small matter to consider of how to pay it all off before you get too ‘old and boring’.
Time to pay up then! Let’s take a look at that in our next post here.