Getting Your Foot On The Property Ladder – A Guide To Mortgages For First-Time Buyers
Chapter Nine
Story Highlights:
This chapter takes a closer look at the most common types of mortgage on the market with key facts about:
- How mortgages work
- The 2 types of variable-rate mortgages
- Tracker, discount and fixed-rate mortgages
- Whether to take out a variable- or fixed-rate mortgage
- Other types of mortgage
- Offset mortgages
- How current account mortgages differ from offset mortgages
- What it means if your mortgage is flexible
- Guarantor mortgages
- Interest-Only mortgages – How they differ from repayment mortgages
The main kinds of mortgage and their differences
Mortgages are a complex financial product and before you start shopping around for the best type for your individual circumstances, you must have an idea of how they work, all the terminology lenders use and the special features of a mortgage. This is important since some initial deals offered by your mortgage provider may seem attractive at the beginning but it’s important to know how this will affect how much you’ll end up paying in the long-term.
As a result, the aim of this chapter is to guide you through the main kinds of mortgage available on the market, what they are, how they differ and their advantages and disadvantages. In this way, when you start looking for a mortgage, you’ll know what your lender is talking about and will be able to ask the right questions to get the best possible deal.
How mortgages work
A mortgage is a loan which is tied to a piece of property. You apply to borrow a sum of money and make a financial commitment to make regular monthly repayments until the loan is discharged. In return for the loan, your mortgage provider adds interest to the capital you’ve borrowed.
The vast majority of mortgages are (capital) repayment mortgages so you pay the interest every month and at the beginning a smaller proportion of the capital which is owed. As you pay off more of the capital, the interest you are charged is less and your repayments start to make inroads into the capital until you’ve paid it all off by the end of your term. A mortgage usually lasts 25-30 years although shorter and longer terms are also possible.
Initially, you will pay a certain interest rate for a set period of time. At this stage you’ll be ‘locked into’ this deal for 2, 3 or 5 years (although a 10-year deal is also possible) and won’t be able to switch without paying a financial penalty. After the initial rate, your mortgage might be charged in a different way so it’s crucial you understand what terms you sign when you take out a mortgage.
Mortgage provision is a competitive and crowded market so lenders are always updating and extending the range of the mortgages they have on offer. Let’s look at the different types, starting with variable-rate before explaining fixed-rate mortgages.
What are variable-rate mortgages?
There are 2 types of variable-rate mortgages: tracker and discount. Let’s look at them in depth: what they are and their relative pros and cons.
What are tracker mortgages?
As its name suggests, a tracker mortgage ‘tracks’ (or follows) the Bank of England’s base rate and is directly linked to it – increasing or decreasing according to fluctuations in this rate. Your lender will give the tracker mortgage rate as a percentage above the base rate. Often you’ll be offered the tracker rate for an introductory period and will then be switched to your lender’s SVR (Standard Variable Rate), which is often higher. There are a small number of life-time tracker mortgages available as well.
What are the benefits of tracker mortgages?
In periods of economic stability, tracker mortgages are one of the best to have as the Bank of England base rate remains steady. This means you don’t have to worry about steep increases in your mortgage repayments. Your rate isn’t dependent on the fluctuations of your lender’s SVR, which could be changed without the base rate being increased.
If you also have a flexible mortgage, you can choose to make overpayments without having to face extra bank charges. These could reduce the total length of your mortgage (thereby reducing the amount of interest you’ll pay) or could give you freedom to make smaller repayments in months when you have a lot of expenses.
Summary:
Mortgages are loans tied to property and are repaid with interest; initially you’ll be locked into a certain deal which may change later.
There are 2 types of variable-rate mortgage: tracker and discount.
Tracker mortgages are linked to the Bank of England’s base rate and change in accordance with it.
In times of economic stability, tracker mortgages are stable and give you the chance to make overpayments if you have a flexible mortgage.
What are the drawbacks of tracker mortgages?
Nobody can predict what will happen to the Bank of England base rate so the main disadvantage for you is that if it increases, your mortgage interest rate will also go up. This could make repayments difficult if you’re on a tight budget since you’ll have to find the cash to cover the increases.
Another disadvantage to bear in mind is that you’ll have to pay an ERC (Early Repayment Charge) if you pull out of the mortgage before the agreed term.
Questions on UK mortgages
A mortgage is a specialised type of loan that is used toward the purchase of a property. When buying a home, you would be required to put down a deposit payment that is usually at least 5% of the property price. You would be required to pay for the rest of the amount using a mortgage from a bank, credit union, or building society. You would be liable to pay the mortgage amount plus interest in monthly payments for certain number of years.
Two main types of mortgage are offered in Britain. The main differentiation lies with how the interest rate is applied. Fixed rate mortgages are those which impose interest that stays the same for a number of years (typically two to five). Variable interest mortgages work with an interest rate that changes on a frequent basis, therefore changing the amount that you pay.
An offset mortgage is a type of loan that is linked to your savings account. This relationship allows you to reduce how much interest you are charged. Your lender uses your savings to deduct from your mortgage balance and only charge you interest on the remaining amount.
What are discount mortgages?
Discount mortgages are linked to your lender’s SVR so they can change independently of any changes to the Bank of England’s base rate. A fixed amount is discounted so they are set below the lender’s SVR. Your mortgage might be ‘stepped’ which means you pay a set rate for a certain period and then a higher rate for the remainder of the time.
Discount mortgages are linked to your lender’s SVR so they can change independently of any changes to the Bank of England’s base rate.
To make rises and falls in your interest rate more stable for you, your variable rate may be ‘capped’, which means it never rises above an upper limit or it could be ‘collared’ so that the rate never goes below a lower limit. Deals for discount mortgages usually last 2-5 years and when this term finishes, you are automatically transferred to your mortgage provider’s SVR.
What are the advantages of discount mortgages
The main benefit of a discount mortgage is that for a certain period, you’re guaranteed that your interest rate will always be below your lender’s SVR. In a time of economic stability when the SVR is low, you’ll be able to take advantage of the fact that your interest rate will be even lower.
What are the drawbacks of discount mortgages?
Lenders can change their SVR without warning and this can have a direct effect on the size of your mortgage repayments. This is something to bear in mind if you’re interested in a fixed monthly repayment so that you’re able to budget. When your discounted period finishes, you may have a shock when you are put on the lender’s SVR and your repayments increase sharply. Finally, with discount mortgages you will also have to pay an ERC if you repay part/all of your mortgage before the end of your deal.
What are fixed-rate mortgages?
Fixed-rate mortgages mean that you pay the same interest rates irrespective of changes in the Bank of England’s base rate or your lender’s SVR. You therefore have the security of knowing that your interest rate and your monthly repayments will stay the same for a set period. Most fixed-rate mortgages are set for a period of 2-5 years (although 10 years is also an option) and then you’ll be automatically transferred to the lender’s SVR.
What are the advantages of fixed-rate mortgages?
The reason why so many home buyers choose fixed-rate mortgages is that they have the peace of mind of knowing that their repayments won’t fluctuate which enables them to handle their finances better. Even in times of economic instability, fixed-rate mortgage holders are unaffected by increases in interest rates elsewhere. Some interest rates for these mortgages are extremely cheap and although the rate for 10-year deals may be higher, you’ll probably end up paying less in the long run.
Summary:
Tracker mortgages have the main drawback that if the Bank of England’s base rate goes up then so will your mortgage repayments.
Discount mortgages are linked to your lender’s SVR and could be stepped, capped or collared.
Discount mortgages are guaranteed to be lower than the lender’s SVR for a set period but your repayments will increase when their SVR is raised.
Interest rates and monthly repayments remain stable with fixed-rate mortgages and are unaffected by increases in interest rates elsewhere.
What are the drawbacks of fixed-rate mortgages?
Interest rates may fall instead of increasing and if you’re on a fixed-rate mortgage, one disadvantage is you won’t be able to benefit from this saving. Interest rates for fixed-rate mortgages tend to be higher than variable-rate ones since you’re paying for the added security of knowing how much you’ll pay each month. Although there are special deals available, they are for mortgage holders with a large deposit and/or a larger equity so first-time buyers can’t usually qualify for them at the beginning.
If you see your home purchase as the first rung on the ladder and are planning to upgrade, you should make sure that your mortgage is portable or you could face high exit fees.
If you see your home purchase as the first rung on the ladder and are planning to upgrade, you should make sure that your mortgage is portable or you could face high exit fees. The length of the term you’ll be locked into the fixed rate must also be taken into account before reaching a decision.
Should I take out a fixed- or variable-rate mortgage?
There’s really no definite answer to this question since it depends on a number of variables in your personal circumstances. You should weigh up the pros and cons of each mortgage on offer and consult your mortgage provider when discussing the different options available to you.
The two main points are how important it is to you to have unchanging mortgage repayments and whether you’d be able to cope if the repayments went up.
What other types of mortgage are there?
Offset mortgages
Offset mortgages can be either variable- or fixed-rate (although not discounted) and are linked to one or more bank or savings account. The interest for such mortgages is calculated according to the capital you’ve borrowed minus the cash in these linked accounts.
What are the advantages of offset mortgages?
One advantage of offset mortgages is that your mortgage repayments are calculated on all of the capital borrowed so you effectively make overpayments on your mortgage. This means you could pay the mortgage off more quickly (thereby saving on interest) or you have the flexibility of reducing your monthly payments depending on your mortgage agreement.
An offset mortgage is also flexible as to which account(s) it’s linked to. Even though your loan is linked to your account, you still have access to your savings in times of need as it isn’t locked away. If you’re in the higher or additional rate bracket for income tax, you’ll also make savings on any tax owed on this money.
What are the disadvantages of offset mortgages?
One major drawback of offset mortgages is that they have a higher interest rate than other mortgages and also interest isn’t given for your savings linked to your loan. In order to benefit from an offset mortgage you really need to have enough savings which you can afford to leave in the linked account. This isn’t always possible for first-time buyers. Finally, this type of mortgage isn’t offered by all lenders so you may have to shop around to find the best deal.
How do current account mortgages (CAM) differ from offset mortgages?
Current account mortgages work in a very similar way to offset mortgages but a CAM combines your savings and mortgage in a single account rather than being linked. The size of your savings reduce the interest payable on your loan and will fluctuate with the fall and rise of the balance in your account.
Summary:
Fixed-rate mortgages guarantee stable monthly repayments but you can’t benefit from possible drops in interest rates and the interest can be higher.
Whether to take out a variable- or fixed-rate mortgage depends on your individual circumstances.
Offset mortgages are linked to one or more accounts and are extremely flexible while still giving you access to your savings if need be.
Offset mortgages have higher interest charges and you don’t receive interest on your savings account.
CAM mortgages are similar to offset mortgages but they’re combined in one account rather than being separate linked accounts.
What does it mean if my mortgage is flexible?
Some lenders promote some of their mortgages as being flexible in the way borrowers make their mortgage payments. Perhaps they wish to overpay one month and then underpay when things are tight financially. They may wish to take a payment ‘holiday’, withdraw a lump sum or even pay the mortgage off early and save on interest charges.
This mortgage feature is ideal when you’re in a profession when you have seasonal fluctuations in your earnings, rely on commission or are self-employed with occasional cash-flow problems. However, you should remember that this facility costs extra and you should only add it to your mortgage if you’re sure you’ll make use of it. Also, you should check the terms carefully as there might be limits to how much you can vary your repayments.
What are guarantor mortgages?
Guarantor mortgages are when someone (most often a parent or grandparent) guarantees your mortgage repayments if you aren’t able to pay. To be a guarantor, they have to put up something as security, usually their home of their savings and meet the criteria of the mortgage provider.
What are the advantages of guarantor mortgages?
The main benefit of guarantor mortgages is that lenders will give a mortgage to people who don’t meet their eligibility criteria because of their circumstances such as borrowers who have little/no deposit or low-earners. This gives you the opportunity to buy a home, build up your equity and then re-mortgage at a later date.
Guarantor mortgages are when someone guarantees your mortgage repayments if you aren’t able to pay.
What are the disadvantages of guarantor mortgages?
Mortgage providers require guarantors to sign a document saying they’ve received independent financial advice and know about the risks that their decision carries. The main risk is that they’re liable for the debt if the borrower defaults on their repayments and could lose some/all of their savings, have their own home repossessed and face their credit rating dropping. If the guarantor is using their savings as security, they could lose any interest paid on it and might not have access to the cash until a certain percentage of the mortgage is paid off.
Interest-only mortgages
Unlike all the previous mortgages in this guide which are repayment mortgages, with interest-only mortgages you pay the interest on the capital you’ve borrowed and the capital remains untouched until the end of your mortgage term when it becomes due as a lump sum. To be awarded an interest-only mortgage, you have to prove to the lender that you have a ‘repayment vehicle’ set in place. In other words, you have arranged how the capital will be paid off. For example, with savings, investments or other assets.
What are the advantages of interest-only mortgages?
The main benefit of interest-only mortgages is that without having to pay off the capital, your monthly repayments will be lower. This will give you more disposable income to invest as you see fit. They’re also ideal for property owners who don’t want to own the property in the long-term or who are planning to down-size.
What are the disadvantages of interest-only mortgages?
Although a third of all mortgages in 2007 were interest-only mortgages, they have since declined in popularity and many lenders have pulled out of the market completely so you might find it very difficult to take out this mortgage. If you’re a first-time buyer, it will be impossible.
The main cause of their decline – and their major drawback – is that there are problems with borrowers putting forward a credible repayment plan. Any kind of investment can be risky and there can be major difficulties if there’s a shortfall in the money owed. Although this mortgage seems cheaper than repayment mortgages, interest is charged on the whole of the capital for the entire term of the loan. As a result, such mortgage holders end up paying much more in interest than other borrowers on capital repayment mortgages.
Summary:
Some mortgages allow a degree of flexibility in mortgage repayments but the borrower is charged extra for this feature and often there are limits.
Guarantor mortgages allow a relative to put up assets as security so that a mortgage will be awarded but this carries an element of risk for them.
Interest-only mortgages mean that you only pay off the interest and the capital becomes due at the end of the mortgage.
These mortgages have lower monthly repayments but the borrower must have a plan in place to repay this lump sum and there’s some risk with counting on investments.
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