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  • Which Mortgage Should I Get?

    14th November 2017

    Which Mortgage Should I Get?

    First – What is a Mortgage?

    A mortgage is any loan that uses real property (land and anything immobile attached to it) or personal property (anything else: clothes, car, furniture) as security for that loan. By far the most common type of mortgage and the most relevant for anyone who has found this guide, is a real property mortgage.

    It’s easy to be overwhelmed at first when looking into property mortgages. There are many guides as well as advisors who will highlight the sheer magnitude of the range of different mortgages available to you. But breathe! It’s ok, firstly your mortgage advisor should help you through this and secondly, we’re here to help break down the confusing world of real property mortgages, for simplicity sake from now just referred to as ‘mortgages’.

     

    How to pay it back: The difference between a Repayment and Interest-Only mortgage

    All mortgages fall under these two categories, with the majority being repayment, so already we’re breaking down this aforementioned huge variety into smaller groups. So, what do we mean by repayment or interest-only?

    Repayment

    Repayment Mortgage – rate of ownership increases over time

     

    Otherwise known as a capital repayment mortgage, this loan is gradually repaid over it’s lifetime. In both cases you will be making a monthly payment to your lender but for the repayment mortgage this will be higher than the interest-only. Think of the repayment mortgage being comprised of two parts; interest + repayment.

    This repayment percentage is designed to guarantee that you have fully eradicated the initial loan by the end of the repayment timescale, typically 25 years. Not only does this leave you without the initial debt at the end of the timeline, but it also allows you to renegotiate on better terms during the lifetime of the mortgage. As time goes on, you own more of the property which reduces the loan to value ratio (how large your loan is compared to the value of your house) giving you access to better rates.

    It is also important to note that as you pay off more of your mortgage you owe less interest because the size of your loan has reduced. But your monthly payment stays the same. This means that over the life of the mortgage, more of your monthly payment goes towards repaying the loan than paying back the interest. The speed at which you own more of the property speeds up.

    • You completely own your property at the end of the loan
    • Opportunity for advantageous re-mortgaging further down the lifespan of the loan
    • Lower overall interest payments
    • Higher monthly payments

     

    Interest-Only

    Interest only mortgage – payments are purely interest and do not contribute towards ownership

     

    An interest-only mortgage is very simply only making monthly payments towards the interest on the loan and making no repayments toward the loan This means that your monthly payment to your lender will be less than with a repayment mortgage, but at the end of the duration of the mortgage you will still be liable for the full sum that you borrowed. If you can’t pay it back you’ll have to sell the house and you may well have just rented due to the reduced risk.

    It is important to note that most lenders will not let you borrow using interest-only unless you can arrange a separate system of repayment for the loan, such as investments or savings. It is also worth noting that over the course of the lifetime of an interest only mortgage you will pay far more interest than a repayment mortgage of the same duration and value because the value of the loan does not decrease over time.

    • Lower monthly payments
    • You still have to find the sum of the loan to repay at the end of the mortgages lifetime

    Ultimately, all mortgages default to your lender’s SVR or standard variable rate, regardless of which type of mortgage you choose.

     

    Which Interest Rate – Fixed or Variable?

    The next step to simplifying mortgages is to decide whether you would like a fixed or variable rate. A fixed rate mortgage will require the same total payments for the duration of your mortgage deal, whereas a variable rate will vary along with either an index or a rate set by your lender. It is important to note that all mortgages default to your lender’s SVR or standard-variable rate after the introductory deal.

     

    Fixed Rate

    So, a fixed rate mortgage does exactly what it says on the tin – you have a fixed percentage fee payable for a set number of years, ranging from 2 to 10 years on average. This rate won’t change for the duration, but will be higher than a comparable variable rate at the time of arrangement, the advantage being if variable rates rise you are protected from the adverse effects.

    The downside to a fixed rate then is if mortgage rates go down or stay the same, as ostensibly you’ve paid more than you would have done on a variable rate. You may also have to pay charges if you would like to switch mortgages during this period or pay off a substantial sum of your loan. Once your period of fixed rate on your mortgage comes to an end you will normally be transferred to your lender’s SVR (Standard Variable Rate).

    • The amount you pay each month doesn’t change, so it’s easier to budget
    • You aren’t at the whim of market movements
    • When variable rates are low, fixed rates lower giving you access to great rates
    • If interest rates fall or are stable then you end up paying more
    • The larger the deposit and the higher your LTV (loan-to-value) the better the fixed rate deal, leaving many unable to access them

     

    Variable Rate

     There are several different types of variable mortgages but they all follow the same principle, that they vary! How they vary is where they differ. SVR or standard-variable rate mortgages is your lender’s base rate, that they set themselves. Typically they follow the Bank of England’s base rate with some other considerations thrown in, but ultimately they are set and change at the whim of your mortgage lender. This is the rate that you will be transferred to after any special or introductory rate you are on finishes, these would be your tracked or discount rate.

    All variable rates share the same pros and cons, and the details of each we will go into later;

    • The Bank of England base rate is at historic lows, meaning that variable rates are at their lowest as they are indexed against this
    • If the base rate remains low then you will end up paying less than a fixed rate over the same time period and mortgage value
    • There is no rate security – SVRs in particular can vary for any reason or no reason at all
    • If you are on a budget an SVR mortgage is very hard to plan around and you could end up being obligated to pay more than you are capable of

    It’s important to understand whether you can afford to pay a potentially increased rate on a variable mortgage. If rates increase and you can’t afford to make payments then you should definitely not be on a variable rate and should look at budgeting around a fixed rate. Choose which pros and cons suit you best – no one can predict for sure how interest rates will change so there is no point worrying which one will be the most cost-effective. You will only know this in hindsight. You should choose which option you are most financially comfortable with.

     

    Tracked or Discount ?

    A simple way of looking at most mortgage types is to understand that ultimately most will revert to your lender’s SVR, after an agreed period of time. When you have a fixed rate mortgage of five years, for the rest of the lifetime of the loan after those five years are up you will be on the standard variable rate.

    Instead of getting a fixed initial rate you can get a variable initial rate, typically at a much better deal than your lender’s SVR. A tracked rate then will typically use the Bank of England’s base rate as a marker, with a set margin above or below it to give your final fixed rate. A discounted rate is more simply a discount on the SVR, so you will be paying less interest. A tracked rate can last from one year to the entire lifetime of the loan, whereas a discount rate will last between two and five years.

     

    Bonuses?

    Once you’ve covered the different choices outlined above, the structure of your mortgage is largely complete and you should understand how the repayments will look for the lifetime and in more detail for the immediate future, but there are a range of extra conditions that can be used on your mortgage, either to benefit you or because of the loan to value.

     

    Capped Rate

    A capped rate mortgage is very simply a variable rate mortgage where your rate will never go above a pre-agreed level. The current rate is set at a higher rate than other variable mortgages but what you pay now is made up for in added security that you will never be paying more than a certain level.

    Capped mortgages are relatively uncommon at the moment, as we’ve seen such historically low interest rates so there is no need for lenders to be competitive in this specific area of the market. Were rates to increase we would most likely see a rise in capped mortgages.

     

    Collar Rate

    The opposite of a capped rate, a collar rate is a variable rate which can only go so low. These have come about largely as a result of the very low interest rates observed in the market and are designed to protect the lender from having to honour rates that go ridiculously low so as to not be financially viable for them.

     

    Cashback

    A cashback mortgage is one where you are incentivised to take out the loan by a cash payment at the very start, sometimes as a proportion of the loan and sometimes as a fixed amount of cash. These types of mortgages will always have strict early payment rules so as to prevent you from taking the incentive money and then just paying back the loan immediately.

    A cashback mortgage can be useful if you find yourself in need of a cash injection in your home buying process, but if you look at the rates being offered and any other charges associated with the loan you can normally get a better overall deal that leaves you with paying less money overall to your lender.

     

    Offset

    An offset mortgage is linked to a savings account and allows you to use your savings to pay less interest on your mortgage. Essentially the money you have saved and put away is used as collateral against your loan, leaving you with a reduced amount to pay interest on, and so lowering your interest payments. This can come back to you in two ways

    1. You can reduce the amount you pay each month, lowering your payments to your lender as though your repayment amount stays the same, your interest rate decreases and so your overall monthly repayment decreases, following the formula monthly payment = interest + repayment

    2. You carry on paying the same amount monthly but you end up paying a great amount towards repaying your mortgage, reducing the lifetime of the loan.

    When your savings are used in this way they remain accessible to you, your interest being worked out on a month by month or sometimes even day by day basis. What this can mean is that your money does more work for you than if it were in a regular savings account, as you don’t earn interest on it but it reduces your interest repayment on your mortgage. If your mortgage rate is higher than your banks interest rate this means that you are effectively saving yourself more money than you would have been making from the savings

    For higher rate taxpayers this can be even more useful, as money you save on your mortgage is not taxable, as opposed to money you make on your savings being taxed no matter how much you’re earning from it at the 45% rate, or 40% being payable on anything you earn in a year over £5,000 for those who earn within that tax bracket.

     

    Flexible

    Flexibility of a mortgage can refer to a number of different options when it comes to dealing with your repayments. It is important to note that this does not mean you can repay what you like when you like, but it does open up a dialogue with your lender. The simplest option to understand is overpayment, where you can pay more than you owe for that month to clear away more of your debt. Many mortgages have fees for early repayment, or repaying more than say 10% of your mortgage per annum.

    Understanding that you can overpay on a mortgage makes it easier to understand that you can also underpay, or take a payment holiday, obviously with the agreement of your lender. Typically you will only be able to access this if you have previously overpaid on the mortgage, but if you know you’re entering into a period of financial difficulty, or that you will have large expenses for a short period of time then it’s always best to discuss with your lender. The interest rate will still carry on being charged during a payment break or underpayment, so you may have more interest to pay back once normal service resumes.

    Another way your mortgage can be flexible is with a borrow back facility, where you can take money back that you have previously overpaid into your mortgage, functioning very similarly to an offset mortgage, where your mortgage can act as a sort of de facto savings account, and in that way similarly to the offset mortgage it can be a more efficient way of making your money work for you.

    Some mortgages also come with what’s referred to as a ‘drop-lock’ function, where you can start off on a tracker mortgage but with very little effort switch to a pre-arranged fixed mortgage rate.

    Please note, this does not constitute financial advice and should be considered a guide to help you ask the right questions when talking to a mortgage adviser, broker or independent financial advisor.

     

    See where mortgages fit into the process of buying a house.