When you take out your first mortgage one of the biggest decisions you need to make is how you would prefer interest to be charged – either on a fixed or variable rate basis
With a fixed rate mortgage you are charged interest by your lender at a set rate for an agreed period – for example you may get a deal charged at 3% interest for three years. In the UK the majority of fixed rates available have initial terms of between two and five years although lenders may offer fixed rates for anything from one to 25 years.
No matter what happens to wider interest rates, your mortgage payment is fixed for that period. This means you will know exactly what your monthly repayments are for the period of time you agreed to. They will not go up or down. At the end of the fixed period, you will either revert to your lender’s Reversionary Rate or you can choose to remortgage to another deal, for example another fixed rate.
Alternatively, a variable rate mortgage moves up and down in line with wider interest rates, so your rate of interest and therefore your monthly repayments can change. This means that you do not have certainty about your repayments because they have the potential to increase or decrease.
Some people do not mind this, especially as it is possible that your mortgage repayment may reduce if rates go down. In addition, some variable rates can be very low indeed, such as discounted variable rates or discounted trackers.
In fact, the very cheapest mortgage rates available are often on a variable rate. According to financial information provider Moneyfacts the average two-year tracker at the end of July 2015 was 2.01%*.
Borrowers with flexibility in their monthly budget, to allow for any possible rate rises, may prefer to take out a variable-rate mortgage.
The biggest advantage of a fixed rate is that you know exactly what your repayments will be for a pre-agreed length of time. This gives you peace of mind when it comes to budgeting, because your mortgage repayments are set in stone. This protection against interest rate rises is essential to some borrowers, for example first-time buyers who don’t have a lot of leeway in their budget, and cannot afford to be hit with an increase in monthly repayments.
In the current climate fixed rates are also relatively low. In fact, according to Moneyfacts, fixed rate mortgages fell to their lowest ever level at the end of July, standing at 2.70%* with average two-year fixed rates at just 2.87% in May 2015.
While fixed rates offer borrowers invaluable security by locking your rate, there are downsides. If the Bank Base Rate falls your mortgage payment will remain the same for the fixed period you have entered into. If you decide to switch or pay off your mortgage during your initial fixed period (for example because you need to move house or sell up), you could be charged. Fixed rates usually come with costs called Early Repayment Charges which are basically penalties for leaving the mortgage before the end of your agreed period.
The charges can be expensive, ranging from one to five per cent of your outstanding balance, so they can easily run to thousands of pounds. Because of this, longer-term fixed rates are best suited to borrowers who expect to remain in their property and their mortgage for the duration of the deal. If you think you might want to sell in a couple of years, for example, it may not be wise to opt for a 10-year fixed rate mortgage. *Source: Moneyfacts 30/07/15
Ups and downs
Fixed rates are set in stone and easy to understand. But there are different types of variable rate that all move up and down in line with wider interest rate movements. Below we run through some of the main ones:
Your pay rate tracks either the Bank of England Base Rate or a lender-specific Variable Rate at a set margin – such as Bank Base Rate plus 1%, which would currently mean a pay rate of 1.5%. If the Bank Base Rate moves up by 1% so too does your pay rate. If it is cut, your pay rate automatically drops by the same amount. At the moment the Bank Base Rate is at its lowest ever level but there are no guarantees it will stay that way. The only way to be sure of your monthly repayments is to fix them for a set period. Capped rate
Your pay rate moves up and down in line with the lender’s Variable Rate but there is a maximum cap beyond which it cannot go. So while your rate isn’t fixed you have pre-agreed the highest level your pay rate can go to during an agreed period.
Discounted variable rate
This is a discount from the lender’s Variable Rate for an agreed period of time, for example 2% off the Variable Rate for two years. Your rate goes up and down in line with the lender’s Variable Rate since it is pegged to it. At the end of the two years your pay rate reverts to the lender’s Variable Rate and you are free to remortgage.
What is an offset mortgage?
An offset mortgage links up the money you have in credit (your savings) with what you owe (your mortgage) and works out the best rate of interest on the overall balance. You can choose either a fixed or variable-rate offset mortgage. For example, you might have a £250,000 mortgage that you currently pay 3% interest on, and £50,000 in savings that you earn 1% interest on (remember, interest is taxed so in reality you get less than 1%).
With an offset mortgage you can ‘offset’ the £50,000 savings against the mortgage balance of £250,000. This means you sacrifice the interest of 1% on the savings and pay 3% on a mortgage balance of £200,000.
Repayment vs interest-only
With a repayment mortgage (also known as a capital and interest mortgage) each month you pay off a portion of the amount borrowed (the capital) as well as the interest on the loan. As you are paying the loan back over your mortgage term, as long as you keep up your repayments, you should be mortgage-free at the end of it.
This is a safe and secure method of repaying your mortgage, as both the interest you owe and your original debt are built into the repayments.
The alternative, interest-only, used to be very popular in the 1980s and ’90s. With an interest-only mortgage, your monthly payments only cover the interest part of your loan. At the end of the mortgage term, you’ll still need to repay the amount you originally borrowed so you will need to consider your repayment strategy and confirm with your lender that this is acceptable to them. You will also need to check with your lender whether or not they offer interest-only mortgages as many lenders have recently restricted their interest-only criteria.
Some lenders offer ‘part and part’ mortgages, where part of your mortgage will be on a repayment basis and part will be on an interest-only basis. As with interest-only, you will need to check with your lender if this repayment method is acceptable and the full terms and conditions.