Choosing the right mortgage

Navigating your options

As the market has become more competitive in recent years mortgages have also become increasingly complex and until recent times this has lead to a much wider choice of mortgage schemes available to borrowers.

Usually a mortgage is repayable over a term of twenty five years, although depending on the borrowers own personal situation and the lenders criteria, it has been possible to arrange a longer or shorter-term deal, and even vary the length of the repayment schedule throughout the term. Even during the current economic climate, which has dramatically reduced accessibility to mortgage schemes, there are still numerous ways of paying a loan back.

Historically lenders have offered a range of different mortgages with varying interest rates, but the credit crunch has lead to many of these being withdrawn.

Typically mortgage schemes have been based on the lender's standard variable rate (SVR), a rate above the Bank of England base rate, which the lender can change at any time. However, many mortgage borrowers opt for mortgage products other than SVR mortgage schemes. These include:

Discount mortgage
This offers a certain percentage off the lender's SVR for a set period, usually between one and five years. As the SVR moves, so does the pay rate on a discount mortgage, so the borrower needs to be able to cope if their monthly repayments increase.

Tracker mortgage
This also has a variable rate, this time usually linked to the Bank of England’s base rate. Sometimes this continues for the length of the mortgage, sometimes it is only for a short period at the beginning of the loan.

Some lenders may offer discounted trackers, which have a rate that is a set percentage below the base rate, while others add a percentage to the base rate. Both deals move up and down in line with any changes announced by the Bank of England. When rates are going down the borrower is the winner, but when rates start to increase so will the mortgage repayments.

Fixed-rate mortgage
This allows the borrower to fix the rate of interest they pay on their loan for a set period of time, usually between one and five years, although longer term fixes may be available. This is useful if the borrower wants to ensure that their repayments do not increase during the fixed-rate period. Fixed-rate mortgages can save the borrower money if interest rates are rising, but if the base rate falls they may end up paying more than other borrowers on variable rate deals.

A small handful of mortgages will track a different index to the base rate, often the Libor (London InterBank Offered Rate). It can be difficult to keep track of the rates on these loans, so they tend to be less popular with borrowers.

Most lenders apply early redemption charges during a fixed or discount period. This can make it costly to move the mortgage during that time. Many short-term mortgage deals revert to the SVR after the initial offer period, which could mean that repayments increase.

Capped-rate
This provides the security of knowing that the interest rate is guaranteed and will not exceed the fixed level during the capped-rate period. With this deal the interest rate can go down and the borrower benefits when rate cuts are announced by the Bank of England.

Interest-only or repayment
Once a decision has been made on the type of loan, the borrower has to choose whether to opt for an interest-only or repayment mortgage. With an interest-only mortgage each month the borrower repays just the interest incurred on their borrowing. The capital is only repaid the day the mortgage ends, and can be paid off using whatever money they choose. This could be from money built up in a separate investment vehicle or from some other source.

If the borrower has not worked out how to pay off their mortgage by the end of the term they could be forced to sell off their home to settle the debt. Even if they use an investment vehicle to repay the mortgage it might not grow as much as they expect and could end up with a shortfall at the end of the term, so regular reviews are important.

A mortgage can also be split into part interest-only and part repayment, for example, if a top-up loan is taken or the borrower wants to keep their monthly repayments down on part of the debt.

Flexible mortgages
Although there is no set definition for the term, a flexible mortgage is widely accepted to enable a borrower to overpay by any amount without penalty, including redeeming the loan. They also allow payment holidays to be taken or underpayment’s providing the borrower has overpaid enough in advance. A flexible mortgage can in addition provide the facility to borrow back on the mortgage (or drawdown) without charging. Not all flexible mortgages offer these features, and some are also available on "regular" mortgages.

Offset mortgages
Offset mortgages allow the borrower to combine their borrowing with their savings. This is a kind of flexible mortgage with an extra feature enabling the combination of borrowing with savings and reduces the amount of interest paid over the mortgage term.

The borrower’s savings have to be moved to their mortgage provider, and as a consequence will miss out on earning interest on their money, but offsetting can make a big difference to the total cost of the loan. The money is kept separate and can be accessed if required.

Current account mortgages are a similar proposition, although they combine the borrower’s day-to-day banking with their borrowing.

Offset and current account mortgages often have higher interest rates than other loans, and the borrower needs to make sure they have sufficient savings to make them worthwhile.

Buyer beware
When arranging a mortgage there are also other considerations:

Arrangement fees
A high proportion of lenders may charge for the work involved in setting up a mortgage or to reserve a loan at a particular rate. The amounts can vary considerably between lenders. Paying more doesn’t always mean that the borrower will receive a better deal. It is also important to check whether the fee is refundable if the deal falls through.

High lending charge
Borrowing more than a loan to value of 90 per cent may result in an extra fee being charged. If this is the case it is important to find out the amount, but not all lenders make this charge. This is levied to protect the lender in the event that the borrower fails to keep up their payments.

Insurance tie-ins
Some lenders entice borrowers with a lower mortgage rate if they buy their own home insurance products from them. They will sometimes also offer their own mortgage payment protection policy.

Redemption penalties
With mortgage special offers, such as fixed rate schemes, a penalty will normally be charged if the loan is paid off early within the offer period. Borrowers should avoid loans with redemption penalties that extend beyond the end of the offer period, otherwise they could be stuck on the lender’s standard variable rate.

Annual percentage rate (APR)
The APR tells prospective borrowers the interest rate over the life of the mortgage. This factors in any initial offer rate and then the lender’s SVR to which the mortgage reverts, as well as the impact of fees. The APR does not include the potential costs on leaving the mortgage, such as administration fees and early repayment charges.