Mortgage types explained


Alan Shaw

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Different Types of Mortgages

In today's market, there's a big variety of different rates to choose from, so having all of the mortgages explained clearly is important. The majority of rates nowadays, have 'tie in periods' also known as 'product expiry periods' within which your rate can be either: Fixed rate, tracker rate, discount, standard variable rate (SVR), capped or collared (see further down this page for full explanations).

The period is usually 2-5 years, however there are some 1 year periods around, some 10 years, some even lasting for the entire lifetime of the mortgage. After the product expires, the rate usually automatically reverts to that lenders standard variable rate (SVR), although some products do exist that switch to something else, a discount or lifetime tracker rate for instance.

There's a whole host of factors to consider when selecting the most appropriate mortgage rate, so your adviser can help you establish which would best suit you.

Fixed Rate Mortgages

fixed rte mortgage
Fixed rate

Fixed rate mortgages are set at a specific rate for the length of the product period, then most fixed rate mortgages switch to the standard rate. As in the example, the fixed period is for 3 years followed by the lenders standard variable rate. This fixed rate example is not an accurate representation of what it could be for you. Ask your adviser for a clear idea of clear representation.

 

Tracker rate mortgages

Tracker rate mortgageTracker rate mortgages are set at a specific margin above the Bank of England base rate for the length of the product period, then usually reverting to SVR. This type of mortgage rate can change monthly if the Bank of England changes its rate so there is the risk of your payments increasing, but it may be a slightly cheaper rate than a fixed to start with. For example, a rate of 4.0% above the Bank of England base rate (often shown as 4.0% + BBR). If the base rate was 0.5%, then the total rate charged would be 4.5%.

Standard variable rate (SVR) mortgages

standard variable rate mortgageThe Standard Variable Rates is the basic rate a lender will charge it's customers for borrowing not tied into a specific product. They are free to change this rate when they feel appropriate so there is the risk they may increase it if necessary. This has been known to happen in the past with lenders like Natwest, Santander, Halifax, Bank of Ireland etc. all responding to the increased cost of lending. As the pressure on the economy has meant it costs them more to borrow the money themselves to lend out to customers.

 

Discounted Rates

A discount rate mortgage is where a lender gives a discount from the standard variable rate for the period of the product. Similar to a tracker, this mortgage does follow changes on a monthly basis, but relates to the lenders SVR and not the Bank of England base rate. There is usually no tie in period when a mortgage is on SVR, and no repayment penalty to settle the mortgage.

Offset Rates

Offset mortgageAn offset mortgage is where the borrower has both a mortgage and savings in the same account. Any savings are deducted from the balance of the mortgage before the interest is calculated. For example, a £100k mortgage charged at a rate of 3.5%, with £20k of savings in the account, would actually only have interest charged on £80k. If there was £5k in the savings account then the 3.5% would be charged on £95k. Usually the savings are easily accessed and there's no penalty for adding to or spending the money. Please bare in mind that these are just example, made up figures, and do not necessarily closely represent your personal situation. Actual rates would depend entirely on your circumstances. You can ask one of the adviser’s for a personalised illustration free of charge.

Capped mortgage rate

This is a rate which can go up or down (usually linked to bbr) but has a limit set to prevent it going too high.

Example- a 3 year tracker rate at 4% with a cap stopping it going any higher than 5.5%.

Collared mortgage rate

Similar to capped, but instead of stopping the rate going any higher, it prevents it from going any lower. Example - a 3.5% discount rate with a collar at 2%. For cap & collar mortgages, these can be found together on the same product, where you'll have a rate that can't go higher or lower than a certain rate. They can also be an added feature of any other product.

Example - a 3.4% 4 year tracker rate with a cap at 5% and collar at 2%.

Low start mortgages

This mortgage type offers borrowers the opportunity to have a low repayment/interest only/low interest mortgage for the first 1-3 years of the mortgage, followed by increased payments for the rest of the term. Ideal for first time buyers who may want to use every penny they have to renovate/ buy furniture/ settle into their new home.

Example - 3.59% tracker with first 2 years interest only, followed by 3.59% tracker full repayment for 25 years.

Repayment Options for Mortgages:

Aside from selecting the right rate, you'll also need to decide how you want to repay the mortgage before the end of the term. There's 2 methods to consider - Repayment or interest only.

repayment vs interest only mortgage

  • Repayment
  • Interest Only

Repayment is probably is the most common and considered by many as the safest and most reliable option and is quite literally paying back the mortgage with every monthly payment. This way you KNOW the mortgage will be repaid by the end of the term because you repay it as you go.

Interest only mortgages are set up to just repay the mortgage interest with every monthly payment, none of the actual mortgage is paid back, so at the end of the term you'd still owe the money. The idea is that the borrower finds an alternative way of raising the money to do this over the term. This can be anything - a tax free savings vehicle like an ISA, the sale of a property, an inheritance, or perhaps (if it’s a buy to let mortgage ) no repayment vehicle at all.

Historically, many people had interest only mortgages and then paid what would have been spent on repaying the capital every month into an endowment policy. Endowments are investments managed by an insurance company who aim to get the best return on your cash. The plan for many was to save in this way instead of repay the mortgage, because the investment would earn more interest than they'd pay on the mortgage and effectively repay it quicker.

Unfortunately due to the financial climate, returns on the majority of endowments have been poor, leaving many borrowers nearing the end of their mortgage with huge shortfalls to make up. As many will also be approaching retirement at this point, it has caused some very major issues for customers and lenders alike. For this reason the Financial Services Authority have tightened the regulation around interest only lending, making it clear that the borrower must have an acceptable and appropriate repayment vehicle if taking any amount on interest only. This is a positive step towards protecting borrowers, however does cause issues with those already on interest only mortgages without an acceptable repayment vehicle - as they may now be trapped with a lender, possibly on a high standard variable rate, unable to re-mortgage elsewhere.

Interest Only Buy to Let Mortgages

Currently, there is no requirement for buy to let mortgages to have a repayment vehicle. This is because they are viewed as a 'un-regulated' financial product and are not required to meet the same regulated criteria. It therefore allows the borrower to choose between having the rental income in their hand or to use it to repay the mortgage.

So What are the Acceptable Repayment Vehicles for an Interest Only Mortgage?

This will change over time as both regulation and lenders attitudes evolve - so this is a rough outline of some of the vehicles that are currently accepted by various lenders. If you are reading this and want to know anything more specific, please get in touch to discuss with an adviser.

As a general rule, any new lending must be no more than the current or projected values of each vehicle. It is sometimes possible to use multiple repayment vehicles for the same mortgage, and to also have a split with some of the borrowing on repayment, some interest only. Some lenders place restrictions on the maximum/minimum value a vehicle can be. For instance, a lender might decline an application if one of the repayment vehicles was just a relatively small amount in savings - some may stipulate that the vehicle must be valued over a certain sum. Others have different rules however, so if you've been declined once, it may still be worth speaking with an expert.

Endowments

Usually confirmation from the endowment company dated in the last 12 months will suffice. If this projection comes with a lower, middle, and upper figure, then various lenders interpret it differently. Most tend to go on the lower or middle figure.

Savings

Cash saved in the bank can be acceptable to some lenders, not to others. Again lending cannot exceed the total sum of savings, unless used in conjunction with other vehicles.

Pension lump sum

Some lenders accept the 25% tax free lump sum you can draw out of your pension on retirement, so if your pension pot is worth £100k, you could potentially borrow £25k on interest only.

Sale of property

If there's equity in another property, this can be viewed as an acceptable method. For instance if you're borrowing £100000 on interest only, you may need to have 100k equity in another property or multiple other properties. The true value of the property itself will play an important part in calculating the equity, and as a result your new lender will need to value it. This is normally done by their valuation team/outsourced company, who may perform a desktop valuation based on the recent sale values of similar properties in the same area, known as the Automatic Valuation Method (AVM) - there should be little/no cost to the borrower for this unless the valuation is low and it is appealed, then you may be required to pay for a full valuation if necessary.

Investments

Other savings vehicles such as stocks and shares, premium bonds and other bonds. Again up to date written proof would be required.


Additional mortgage features:

There's also some additional features in many mortgages that allow you increased flexibility. You may be able to switch between different types of rate, make over-payments, underpayments, even repay the mortgage in full without penalty.

Flexible Mortgages

These are usually associated with the ability to overpay/ take breaks/ withdraw cash at anytime without additional costs or charges.[/toggle]

Cash back

Usually where a lender pays you a sum once your mortgage has been set up. In the past, cash back mortgages used to reward the borrower up to £1000's, nowadays a sum of £250-£500 is more common. This particularly helps on a purchase or a remortgage product that charges valuation and legal fees, as often it will cover most/all of the cost.

Valuation refund mortgages

Simply where a lender will refund the fee you pay for a basic valuation, when the arrangement of your mortgage is completed.

Porting

If your mortgage is portable, it means you are able to move it from one property to another. So for instance if you move house and have a great rate that you want to keep, then it will be possible to transfer it to the new house instead of paying it all off. If there is a shortfall (so you need to borrow more than your porting) then that is usually borrowed on a new product from that lenders range. If you are paying some of it off at the same time you can, but you may invite repayment penalties for doing so if the sum you're repaying is greater than the overpayment allowance.

Overpayments

Pay extra on a regular monthly basis or as a one off lump sum whilst in the tie in period. Generally, most mortgages now come with an initial allowance of up to 10% per calendar year, for instance if you borrow £100k you could pay back an extra £10k in year one without penalty. Year two, if there's say £90k left you could pay £9k extra etc. It's important to check if the interest on your mortgage is calculated daily/monthly/annually - as this will effect when you should make any overpayments. If daily interest, then whenever you make an overpayment the remaining balance of the mortgage is changed the next day, if monthly then not until the end of the month, if annually then not until the end of the year. For example, paying £10k off a £50k mortgage it doesn't matter when you pay it, as the next day you're interest charged will be based on £40k. If monthly then it may make sense to wait until the end of the month to make the payment, as you'll pay the interest on the mortgage and not receive the interest on your money. If annually then it may make sense to wait until the end of the year before making additional payments, because you'll still be paying the interest on the £50k regardless - your money may as well be earning interest for the year, and then be used to repay the mortgage just before the next years interest is calculated. Every mortgage can be different, so it's recommended that you always seek advice from your lender at the time.

Under Paying

If you've overpaid, you can often underpay. Works slightly differently lender to lender so always be sure that you understand your mortgage clearly. As an example, if you’ve paid off extra 6 months ago, you may be able to pay off less going forward.

Payment Holidays

A great feature that allows you to take a complete break in your payments for a certain period (often up to 6 months - although some lenders are making changes and are beginning to reduce this term to a maximum of 2 months). The majority of lenders only allow this in times of difficulty, such as losing a job or getting ill, and ask the borrower to prove they are in some financial difficulty and struggling to afford repayments. check the terms and conditions here - and if you're wanting to apply for a payment holiday on your mortgage, contact your customer services department for more info, or give our office a call and they can point you in the right direction.

No Early Repayment Penalties (ERC’s)

The majority of mortgages will have penalties to pay should you wish to leave or pay more than the overpayment allowance during the product rate period. Usually anywhere between 1-5% charge on the total balance, depending on the year of the mortgage you're in. Some lenders charge a flat 3% fee, others taper the charge depending on how long you've had the mortgage. A made up example could be a 5 year fixed rate mortgage, if you wanted to settle in year 1 it would be a 5% charge, year 2 = 4%, year 3 = 3%, year 4= 2%, year 5= 1%. After the product expires, there's often no overhang, and you're free to pay off the mortgage without penalty, however some mortgages have a longer tie in period than product period, so be sure to check the terms and conditions of your mortgage. Some mortgages allow you to pay off as much of the mortgage as you wish within the product period, free of charge right down to £1. If you were to completely repay the mortgage then you get charged the repayment penalty on the full balance. These are ideal for anyone looking for a fixed rate for a few years, and are due to come into some money in that time which they'd use to pay off the loan - as they avoid any penalty. Some mortgages don't have any repayment penalty at all - attractive for some who aren't sure how long they want the mortgage for. If you want to make large lump sum overpayments or completely repay the loan, or if you know your plans will change in the short term and want to avoid paying penalties should this be the case.

Borrow Back

Allows you to take back any overpayments as cash. For example if you have paid £30k extra into the mortgage over the last 10 years, you could request some of that money back and start paying the mortgage based on it being £30k more.

Switch and Fix Mortgages

These allow the borrower to take a tracker rate initially, and then fix the rate at a later point without penalty, if they are concerned about rates rising.


What is the 'mortgage term'?

The length of time it takes to repay the mortgage. Historically 25 years was the default term for any new mortgage, nowadays it's more common to just pick the best term to suit your circumstances. If you've got a big budget and want to pay it off ASAP, have a shorter term, if you want to minimise monthly outgoings despite increased total cost, stretch the term.

What fee's should I expect?

See our mortgage fee's page here.


Now you know about the different types of mortgage, you might be thinking…

What Type of Mortgage Should I Get?

In mortgages, and the rest of the financial world, there tends to be a lot of jargon and confusing information out there. If you do plan on reading up on things here then great, it's important to know the basics.

Types of mortgage loans, types of home loans, first charges, secured loans, mortgages - they all really mean the same thing - a loan for which the property is security, for the lender to repossess and sell should you not pay the money back.

Never take such a financial commitment lightly, don’t be pressured and always be sure that you have a strong understanding of what you’re getting yourself into. All the example in this article are just examples, the figures won’t necessarily apply to you. The actual rate available will depend upon your circumstances so ask an advisor for a personalised illustration.

Before making the decision on which mortgage might be best, it would be a good idea to ask your adviser to clarify any questions, and to have all the different types of mortgages explained, as well as go through what's available in the current market.


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