Different types of mortgages and what they mean

types of mortgages

With so many different types of mortgage available, it can sometimes be a minefield knowing which is most suitable for your needs.

If you’re buying your first home or making your way up the property ladder, you’ll need to think about your mortgage from the get go. But trying to get to grips with the wide range of different types of mortgages available and translating the complex financial terminology that fills applications forms and mortgage illustration documents, can all feel hugely overwhelming!

  • What type of mortgage can I get?
  • How much interest will I be paying?
  • What is the mortgage rate?
  • How many years should I choose to repay my mortgage over?
  • Is it better to have lower monthly repayments, but a longer mortgage term and pay more interest, or should I choose a shorter term and higher monthly repayments?
  • What do the different types of mortgage really mean, and which one is best?

These are all questions that can cause stress and anxiety when it comes to buying a home.

What are the main different types of mortgages?

There are two main types of mortgages available; fixed rate and variable rate. 

Fixed rate mortgages can be interest-only or repayment.

Variable rate mortgages can include tracker mortgages, discounted mortgages, and any other mortgage product that has variable mortgage rates.

Mortgages explained:

What is a fixed rate mortgage?

A fixed rate mortgage is one where the interest rate will stay the same for the entirety of your initial deal period.  The fixed rate period usually lasts between one and five years, depending on which mortgage product you choose.

The benefit of a fixed rate mortgage is that you will know exactly how much your mortgage repayments will be each month until your deal runs out.  At that point you can secure another fixed rate deal.

Fixed rate deals require mortgage providers to attempt to see years into the future, and calculate what they think the Bank of England base interest rate might be.

If you tie in to a fixed rate deal at the right time, when interest rate are low, you can secure yourself a low rate and end up paying considerably less interest than other homeowners in a similar position.

Time it badly, however, and you could end up tied into a fixed-term deal with a considerably higher interest rate than others around you.

Should I fix my mortgage?

All types of mortgage products offer different benefits.  If you are considering whether to choose a fixed or variable rate mortgage, it is important to consider how important budgeting is for you.

Fixed rate mortgages are great for those who like to have an exact monthly budget and know well in advance what their financial outgoings will be each month.

If, however, you would prefer to benefit from any drop in interest rates, and are prepared to take the hit if interest rates rise, then you might be better to look at a tracker or other variable rate mortgage.

If you choose to go for a fixed mortgage, make sure you think carefully about how long you want to be tied-in for.

If you think interest rates are likely to rise significantly, you would be wise to select a longer deal.  If, on the other hand, you think interest rates are likely to be changeable and may well go down, you would probably prefer to go for a shorter term and have the ability to renegotiate a new deal sooner.

What are variable rate mortgages?

A variable rate mortgage is any mortgage without a fixed monthly interest rate.

The interest rate you pay on a variable rate mortgage can go up or down each month.

Examples of variable rate mortgages include tracker mortgages, discounted rate mortgages or mortgages on the standard variable rate.

The ‘standard variable rate’ is the interest rate you will be moved onto once any initial deal has ended.  You will remain on your lender’s standard variable rate for the rest of your mortgage term, unless you move onto another deal.

What are tracker mortgages?

A tracker mortgage is linked to the Bank of England base rate.  If the base rate goes up, your interest rate will go up; if the base rate falls, your interest rate will fall.

A tracker mortgage is great for homeowners who want to take advantage of any fall in interest rates, but makes it more challenging to budget than a fixed rate, as your interest rate could change several times during the course of your mortgage deal.

Tracker mortgages are most commonly available in two and five year deals, so the interest rate for your mortgage will stay the same amount above the Bank of England’s base rate for the period of that initial deal.

Once your tracker deal has ended, your mortgage will revert to your mortgage lender’s Standard Variable Rate.

What are interest only mortgages?

There are two different mortgage repayment types: capital repayment and interest-only.  Interest only mortgages require the homeowner to make interest repayments each month, but without repaying any of the mortgage balance.

The idea is that the homeowner pays into other investments that will enable them to pay off the capital of the mortgage at the end of the mortgage term.  Unfortunately, a challenging financial climate in recent years has meant that many investments have underperformed, leaving homeowners with a financial shortfall and a looming repayment deadline.

There have also been concerns about homeowners taking out interest only mortgages due to the cheaper monthly repayments, with the intention of moving onto a repayment mortgage in the future.  If they are not financially in a position to make the transition to a repayment mortgage, and have not set up financial investments to repay the capital, homeowners face repossession at the end of their mortgage term.

The Financial Conduct Authority (FCA) estimates that there are currently more than 1.5million interest only mortgages outstanding in the UK.

What is an offset mortgage?

An offset mortgage is a mortgage that links to your savings.  You only pay interest on your mortgage balance minus the amount you have in savings, so the more savings you have, the less interest you will pay.  Your savings are not used to pay your mortgage, they simply sit alongside it so you benefit from reduced interest payments.

Offset mortgages can be a confusing concept, which means they don’t have a great uptake, but taking out an offset mortgage could save you a significant amount in mortgage interest.

Example:

Mortgage balance: £100,000

Savings: £20,000

Mortgage interest rate: 3%

Savings account interest rate: 1%

Offsetting your mortgage, and therefore only paying 3% interest on £80,000 (£2,400) instead of £100,000 (£3,000), would save you around £600 a year.

If you put your £20,000 in a normal savings account, with an interest rate of 1% (which is pretty generous in today’s financial climate), you would earn £200 in annual interest (minus any tax payable).

Based on these figures, by offsetting your mortgage you could be £400 a year better off.

An offset mortgage will not be the right option for everyone, however.  Interest rates on offset mortgages tend to be slightly higher that on other mortgages, so you need significant savings to make an offset mortgage financially beneficial.  It is important to seek independent financial advice from an accredited mortgage advisor to find the right mortgage product for you.

What is a discounted mortgage?

The interest rate on a discounted mortgage is a fixed percent below a specified interest rate, usually the lender’s Standard Variable Rate.  Because a discounted mortgage will remain the same amount below the specified interest rate for the initial term, the rate will be variable and could go up or down.

What is the different between the term of the mortgage and the initial deal period?

When you first take out a mortgage, you will normally select an initial deal of anything between two and five years.  Longer deals are available, but are more rare.  You will select what period you would like to repay the mortgage over, but your mortgage lender will tie you in for the initial ‘deal’ period.  During that initial period, if you want to change your mortgage, you will be required to pay a hefty exit fee.

The exit fee (or redemption fee as it is commonly known) is usually a percentage of the amount of money you have borrowed, and the amount will decrease, the closer you get to the end of your deal.  Once your initial tie-in period ends, you have the option to shop around for a new deal, or you will automatically revert to your lender’s standard variable interest rate.

What mortgage types are best?

Mortgages are not a ‘one size fits all’ product.  Which type of mortgage is best for you will depend on your individual financial circumstances.  For that reason, it is important that you seek independent financial advice before applying for a mortgage.

I want to apply for a mortgage, where do I start?

If you want to apply for a mortgage, and are looking to get different types of mortgages explained to you, an independent mortgage advisor is a great place to start.

An independent mortgage advisor can offer advice on how much you might be able to borrow, likely repayment figures, advantages and disadvantages of a mortgage product, and the best financial products to suit your individual requirements.

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