Types of Mortgage
This article aims to provide details about the different types of mortgage available for those considering buying a property. As it is a considerable financial commitment, understanding the different types of mortgage that may be offered by lenders can help individuals in their search for a suitable mortgage. Learn more in the article below.
There are two main types of mortgage:
- A fixed rate mortgage
- A variable rate mortgage
Fixed Rate Mortgages
When you take out a fixed rate mortgage from a lender, the interest rate of the loan remains the same for the length of your agreement. Lenders often offer fixed rate deals of between one and five years, although some lenders may offer a longer period of ten years.
The advantage of a fixed rate mortgage is that the monthly repayment does not change even if the lender’s interest rate changes. This can be helpful for budgeting and provides a degree of certainty about monthly outgoings.
However, the disadvantage of a fixed rate is that if the lender’s interest rate falls, the borrower will not be able to benefits from lower repayments. As the interest rate on the mortgage is fixed, longer deals may have higher annual percentage rates than shorter deals. This is in order for lenders to compensate for the money they may lose on monthly repayments should interest rates rise.
Fixed rate mortgage deals can also include penalties for ending the agreement early or overpaying – but not in all cases, so be sure to ask your advisor or lender about that if you’re considering a fixed rate mortgage.
Variable Rate Mortgages
Variable rate mortgages offer a fluctuating interest rate over the duration of your mortgage, which can change the amount of your monthly repayments. With this type of mortgage, borrowers would need to prepare for the possibility of their monthly repayments increasing if the interest rates rise – but they may also consider the possibility of their payments decreasing if the interest rates drop.
There are a number of different variable rate mortgages available:
Standard Variable Rate (SVR) Mortgages
The interest on a standard variable rate mortgage is set by the lender, who can increase or decrease this rate at any time during the loan. A change in the interest rate may occur as a result of a rise or fall in the base rate set by the Bank of England. SVR mortgages can pose a risk of not being able to afford an unexpected rise in monthly repayments, so this mortgage should only be considered by those financially secure enough to cope with the fluctuations in interest rate.
An advantage of a SVR mortgage is that the borrower is normally free to overpay or leave the agreement without incurring a penalty.
Discount Rate Mortgages
Lenders can offer a discount off their standard variable rate (SVR) for a set period of time, usually two to three years. The lower rate means that the monthly repayments work out cheaper, however when the discount period ends, the interest rate returns to the SVR of the lender and the monthly payments will most likely increase.
As SVRs differ between lenders, a larger discount may not always mean cheaper monthly repayments. For example, a 2% discount on an SVR of 6% will have higher monthly repayments (paying 4% interest) than a smaller discount of 1.5% on an SVR of 5% (paying 3.5%).
Discount Rate Mortgages may also charge penalties for overpaying or ending the agreement early.
Capped Rate Mortgages
The interest rate on a capped rate mortgage moves in line with the lender’s SVR but is capped to prevent it from exceeding a certain maximum. This provides a measure of certainty that the monthly repayments will not go over the specified amount.
However, capped rate mortgages usually have higher rates than standard SVR mortgages as you are paying for the added security.
A tracker mortgage is linked to another interest rate, and moves up or down in line with the rate it is ‘tracking’. For example, if the tracked base rate increases by 1%, your rate will also increase by 1%. Often the tracked rate is the base rate determined by the Bank of England, with an addition of a few percent.
Tracker mortgage rates usually last from two to five years, although some lenders may offer a rate that lasts for the entire duration of the mortgage.
An advantage of this mortgage is that the fluctuation of your rate is determined by the rate it is linked to rather than the lender. However, there may be an early repayment charge should you want to switch before the agreement ends. Tracker mortgage rates tend to be cheaper than fixed rate mortgages, but it can help to shop around to find the best interest rates.
Interest Only Mortgages
An interest only mortgage enables you to pay off the interest of the mortgage without paying the capital. The monthly repayments can work out cheaper; however the entire capital amount would still need to be paid at the end of the mortgage period.
This type of mortgage should only be considered if you have financial plans in place to pay off the debt at the end of the mortgage term. Lenders can request to see a savings plan as proof that you will be able to pay the capital at the end of the agreement. If you are unable to pay, it can result in losing your home to the lender.
An offset mortgage allows you to link your savings account to your mortgage account.
For example, if you were to take a mortgage of £200,000 and link it to your savings of £25,000, an offset mortgage allows you to only pay interest on the difference: £175,000. However, with an offset mortgage the savings no longer earn interest.
Paying less interest means that borrowers can potentially pay off more of the debt in each monthly repayment. This effectively helps to pay off the mortgage sooner than if they were paying interest on the full amount.
However, interest rates for an offset mortgage tend to be higher than other mortgages. If you are considering an offset mortgage, you need to have enough savings to ensure that repayments will be lower in spite of a higher interest rate.
Checking your credit report up to 6 months before applying for a mortgage can give you time to have any errors corrected and address any areas for concern.