What type of mortgage to choose?

what should my mortgage payment be

By Lesley | Edited by Johanna Updated July 2015

Getting a mortgage is one of the biggest financial commitments you're ever likely to make. So it's crucial to understand what type of mortgage will suit you best.

In this guide.

Choice 1: Repayment vs interest-only mortgages

There are three types of repayment structures: interest-only, capital repayment and 'part and part' (which is a mix of the two).

What is a repayment mortgage?

Your repayments are calculated so you'll have repaid all the debt and the interest over the term you agree (eg, 25 years). It means your monthly payments both cover the interest and chip away at the actual debt, so at the end you owe nowt.

This has a strange effect. In the early years, your outstanding debt is larger so most of your monthly repayments go towards paying the interest. Gradually, as you reduce what you owe, most of your repayments go towards paying off the debt.

For example, on a Ј150,000, 25 year mortgage at 3%, you'll pay Ј711 a month. After 10 years you'll have made Ј85,320 in payments, but only reduced what you owe by Ј47,000. Yet after a further 10 years, having paid another Ј85,320, you've reduced the debt by a further Ј63,420. This is because less interest is accruing each year.

Many people, once they realise this, then worry that if they ever remortgage to another deal, they'll lose all the work they've put into decreasing what they owe. This isn't true. Provided you keep the same debt and the same number of years left until it ends (ie, you have 14 years left to repay and you still intend to repay it in 14 years) it stays the same.

To see how your repayments would work in practice, check out our Mortgage Calculator .

What is an interest-only mortgage?

Interest-only mortgages used to be really popular among first-time buyers but since the credit crunch it's highly unlikely a wannabe homeowner will be able to get their hands on one. And new laws that came into effect from April 2014 mean interest-only mortgages will only be offered where there's a credible plan to repay the capital, making them even rarer.

But here is how it works.

Here, you just pay the interest during the term. Your monthly payment doesn't chip away at your actual debt – it just covers the cost of borrowing the money. When the term (typically 25 years) is up on a Ј150,000 loan, you would still owe Ј150,000.

You have to pay back the amount you borrowed in one lump sum at the end of the mortgage term. So if you get an interest-only mortgage, you NEED to have a separate plan to pay off your debt.

The lender will want to see evidence of a convincing method you've set up (eg, savings) to build up enough cash to pay off the actual cost of the property.

So repayment wins hands down?

Putting the fact that it's difficult getting an interest-only mortgage aside, unless you have a compelling reason, repayment is really the way forward. Although you pay more each month, it's the only option which guarantees you owe nothing at the end of the mortgage term, as you're actually paying off some of your debt every month.

And as the capital is gradually reducing, you pay less interest over the term than you would with an interest-only mortgage. When you come to remortgage, you'll have paid off more of the debt so you'll be able to get a mortgage with a lower LTV and hopefully a lower interest rate.

Ready to remortgage?

If you want to change mortgage, this free guide has tips on when you should & shouldn’t remortgage and how to grab top deals.

If you're ready to get a mortgage, tell our Mortgage Best Buys tool what you want, and it'll speedily find the top deals for you.

Choice 2: Is a fixed or variable rate mortgage better?

This is the really BIG choice, and it's never easy. There are many different types of deal but all fall roughly into two camps. They're either fixed or variable.

What's a fixed-rate mortgage?

Think of a fixed rate like this. In return for signing up to it, the lender agrees to give you a short-term special rate. Regardless of what happens to interest rates, with a fixed mortgage your repayments are… er… well… fixed for the length of the deal.

Lenders call this the incentive period - and all fixed deals will have one, whether it's two, three, five or 10 years.

Like all mortgage deals, fixed rates have pros and cons:

    Certainty - you know exactly what your mortgage will cost. Your payments won't go up over the life of the fix, no matter how high rates go. You'll know EXACTLY what you'll pay, meaning you can budget around it. Starting rates are usually higher than on variable products. If interest rates fall, you won't see your payments drop. If you want to get out early, you'll usually pay high penalties.

If a fixed mortgage sounds good, think carefully about how long you want to fix for. Ideally, you don't want to leave the deal before the initial period ends, as there's usually an early repayment charge, which can add significantly to your costs.

Quick questions

Why are the longer fixed rate deals more expensive?

The longer the fixed deal, the higher the rate is likely to be as the lender takes on more risk of interest rates changing while having to guarantee your rate. Like any insurance policy, this protection from rate rises will cost you.

So a five-year fixed will have a higher rate than a two-year fixed. Which to pick? It all depends on what price you put on your peace of mind!

What happens when my incentive period comes to an end?

Don't panic, you're not expected to repay your mortgage in full. If you choose a two-year fixed rate, for example, your rate is fixed for two years and at the end you'll go onto the lender's standard variable rate (SVR).

The mortgage illustration you'll be given by the lender or broker will tell you what today's SVR is. But be aware, this can be changed by the lender at whim, so there's no guarantee what it'll be when you reach the end of your fixed deal.

If the SVR is higher than rates offered to new customers, most people will remortgage (replace the mortgage with a new one) on to a more attractive rate with a new lender.

What is a variable rate mortgage?

Here your mortgage rate, as the name suggests, can and will usually move up and down. The major, but not sole cause of this, is changes to the UK economy.

In times of growth and inflation, interest rates tend to go up to discourage spending. This is to make saving more attractive and borrowing costlier – meaning people are less likely to borrow to spend. In downturns, interest rates are often cut to encourage spending.

To complicate things, variable rate deals fall into three categories: trackers, standard variable rates (SVRs) and discounts.

Tracker mortgages

Here, the rate tracks a fixed economic indicator - usually the Bank of England base rate. This doesn't mean it's the same as the base rate, just that it moves in line with it.

Trackers are popular, especially in times of low or falling interest rates, but there are some pros as well as cons:

    It's transparent as you've the certainty that only economic change can move your rate, rather than the commercial considerations of the lender. Uncertainty - if rates rise, so will yours. You're also locked into a fixed relationship, so if you're paying a a rate several percentage points above the base rate and interest rates jump, it could mean huge future costs.

While the base rate is low (0.5% at the time of writing), the tracker rates usually tracks above it. For example, you might see a deal at 3.14% (2.64% + base rate). If the base rate increases one percentage point, so does your mortgage. If it falls by that, so does your mortgage.

Quick questions

How long can I track for?

Trackers range in length, with the most common being two years. Some trackers are for the full term of the mortgage, called a 'lifetime tracker'.

Like most incentive periods, there's usually a fee to pay if you leave early. Lifetime trackers often don't have any early repayment charge, or only have one for an initial period. It varies, so check carefully.

Do trackers always follow the Bank of England base rate?

Some trackers don't follow the BoE base rate. Instead, they track the Libor rate (London InterBank Offered Rate), which is the rate at which lenders loan money to one another. Libor is more commonly used by 'sub-prime mortgages' and buy-to-let mortgages than standard residential ones, but watch for it.

Watch out for lenders who call their products 'trackers' but have their mortgage deals following a rate the lender controls. For example, Woolwich's tracker range follows the Barclays Bank Base Rate, meaning it's more like a discounted product than a tracker.

Will my tracker only ever move when the rate it follows moves?

A true tracker should only move when the economic indicator it follows moves. But watch out for naughty lenders describing mortgage rates as trackers and then including small print that lets them up rates for other reasons.

Get your lender and broker to confirm there aren't any conditions like this and check the mortgage offer document carefully yourself before you sign on the dotted line. It's rare, but Bank of Ireland did this in 2013 (see the Bank of Ireland MSE News story.)

Standard variable rate mortgages (SVRs)

Each lender has an SVR that they can move when they like. In reality, this tends to roughly follow the Bank of England's base rate movements. SVRs can be anything from two to five or more percentage points above the base rate, and they can vary massively between lenders.

Although rare, these mortgages can be cheap. But they're risky as you don't know when the lender will move its rates - and it can move rates for commercial and economic reasons:

    They can be cheap in some circumstances. If interest rates are cut, your rate will likely drop too. There is usually no early repayment charge meaning the mortgage can be paid back in full at any point without penalty. Uncertainty - there's no guarantee you'll get the full benefit of all rate changes, as you're at the mercy of lenders hiking rates at their will.

SVR mortgages are rarely available to new customers nowadays, and even if they are, they're usually they're not as competitive as other rates. You'll usually only go onto an SVR when you reach the end of an incentive period on another mortgage deal.

Discount rate mortgages

These deals usually offer a discount off a lender's standard variable rate (SVR). Most of the discounts on offer tend to last for a relatively short period – typically two or three years, but there are lenders offering longer, even lifetime options.

Yet be careful when you read the marketing materials. How are they described? It can be confusing. Take, for example, 'a 2% discount'. Is this 2% off its SVR of 5%, ie, 3%? Or does this mean the rate you pay is 2%? Check carefully what you'll pay.

    In the past, this was often the cheapest rate type, but now it's not always the case. If interest rates are cut, your rate will probably drop too. Uncertainty - there's no guarantee your lender will move its SVR down if the Bank of England base rate goes down. So you might not get the full benefit of all rate changes. You're at the mercy of lenders hiking SVRs at their will, which directly affects your rate.

Remember that because lenders' SVRs can vary, it's not the size of the discount that counts, but the underlying rate you pay. ALWAYS examine the entire rate.

Should I go for a capped deal?

A capped deal is a variable rate, a discount or a tracker mortgage which has an upper limit- so the rate has a guaranteed ceiling it can't exceed no matter what the tracked rate rises to.

They tend to be offered most often, and are most popular, when people are frightened that interest rates could soar.

The rate you pay moves in line with the base rate or SVR, but there's an upper ceiling or cap which gives you some protection. They tend to be offered most often, and are most popular, when people are frightened rates might soar.

    You benefit from interest rate falls and have some protection from rises. The cap tends to be set quite high, and the starting rate is generally higher than normal variable and fixed rates.

Capped deals used to be more common, but they are now pretty rare - so the question of whether you should get one may not even come up.

Choosing between fixed & variable

A fixed rate is an insurance policy against hikes and therefore gives peace of mind. That has to be factored into the equation. Though how much that peace of mind costs you is important too.

Yet a shock horror thought from the Money Saving Expert. Here, choosing a rate isn't purely about which is the cheapest.

Deciding whether to fix is a question of weighing up how important certainty that your repayments will stay the same is for you. I tend to think of this as a "how close to the edge are you?" question.

Someone who can only just afford their mortgage repayments should not be gambling with interest rates. They'll benefit much more from a fixed rate as it means they'll never be pushed over the brink by a rate increase during the term of the fix.

Those with lots of spare cash over and above the mortgage may choose to head for a discount or tracker, and take the gamble that it'll work out cheaper in the long run.

Don't look back in anger

I'm sure Oasis were writing about mortgages when they penned that famous line. The truth is, the only way to truly know which mortgage deal is best is with an accurate crystal ball, and they cost way more than a house.

So if you do decide to go for a fixed rate on the basis of surety and later with hindsight realise a discount rate would've been cheaper, this doesn't mean it was the wrong decision. If you needed surety, remember, you got it.

I think it's time for an analogy

If I asked you to call heads or tails on a coin toss and said I'll give you Ј100 if you win, but you only need to pay me Ј1 if you lose, then provided you could afford to lose Ј1, you'd be a fool not to do it.

While the bet itself doesn't increase your chances of winning, the reward for winning is much better than the cost of losing. So if when we actually tossed the coin you lost, that doesn't mean the bet was a bad one. Even though the outcome wasn't what you wanted, you made the best decision based on the knowledge you had at the time.

The same is true with fixing your mortgage.

Quick questions

What's the difference between a tracker and a discount mortgage?

A tracker follows the Bank of England base rate (or less commonly, the Libor rate) which is an independent economic indicator. This means your lender should only move your rate by the same amount and when the indicator moves. (Check the small print to make sure your lender hasn't left itself a loophole here – very rare, but it has happened!).

A discount is priced at a certain percentage below the lender's Standard Variable Rate. The percentage discount cannot change but the SVR, can move willy-nilly based on the lender's own competitive reasons. The most important thing to remember is.

Lenders can do whatever

they want with their SVRs. You have no guarantee on what'll happen with it.

Why do some variable mortgages have a 'collar'?

Between July 2008 to March 2010, the Bank of England base rate dropped from 5.75% to 0.5%. Tracker products were usually priced below base rate (eg, base rate minus 0.2%) so some borrowers did extremely well. But the lenders didn't do quite so well out of it, so some tried to limit their losses by applying a mortgage collar (minimum rate).

A collar stops the rate from falling below a minimum percentage rate - essentially, it's the opposite of a cap. Some lenders were sneaky and introduced this even though it wasn't in the paperwork, though this isn't allowed.

If you opt for a variable mortgage, make sure you check if there's a collar. Ask your lender (or broker) outright AND check the key facts illustration and mortgage offer carefully.

How do I know if I'm getting the best deal?

As rates change over time, simply comparing the fixed and variable rates at the point you take your mortgage is a relatively blunt tool. To work out which is truly a better deal, look at how much interest rates would need to change before one deal beats the other. This is where a broker can really help you see the wood for the trees.

Choice 3: What length of deal should I choose?

Incentive periods range from two to 10 years and picking the wrong length can be costly. Yet many don't think this through fully. This can come back to bite you later, meaning you spend more than you need to.

There are many factors to consider before you choose, the key one being.

"How long do you need the certainty for?"

This is most appropriate with a fixed-rate mortgage, as your monthly payments are fixed for the term. Generally speaking, the longer you fix for, the more it will cost. But if you need the certainty of knowing what your payments will be, a fixed mortgage will do this for you.

When is a 2-year deal NOT a 2-year deal?

Many products will have a name that states the initial rate will last a certain number of years, but will actually have a specified end date.

Depending on how long it takes to complete the mortgage (to draw down the money), you could end up with a product that could last months less or even more than you anticipated. So check the detail carefully.

Don't just rely on the name of the mortgage product on the front page of the illustration. Check the section that details the rate, if it has an end date, it' look something like this:

3.29% fixed, ending 31/07/2016

Before you can select the right incentive period for you, you need to consider the following:

Mortgage fees can add up if you constantly switch deals

Two-year incentive periods are extremely popular because they're usually the lowest rates. But their fees tend to be just as high as longer deals. So think about it - over 10 years, if you have five separate two-year deals, you could be paying Ј7,000 in arrangement fees (Ј1,500/deal).

But if you can get two five-year deals, then you'd only need to pay Ј3,000, potentially saving Ј4,500.

Fees can be even more expensive if you can't pay them upfront. You'd have to add them to your mortgage debt and pay interest on them for many years.

Read our Mortgage Fees guide for a full rundown of what you could have to pay.

How long should I set the term for?

As well as choosing the length of your introductory deal, you also need to choose how long the mortgage will run for. It's an important factor, and it's often overlooked.

Most people plump for 25 years - but it doesn't have to be that long. A shorter mortgage term means higher repayments, but less interest overall. But there's a couple of factors to take into account when you choose:

  • How old will you be when the term ends? Many lenders won't allow you to take it into your retirement period. This is probably good for you too – as you have to question whether you could you keep up with the repayments.
  • The longer it is, the more you pay. Lengthening the term to, say, 30 years means you pay less each month, but you pay more interest in total. Shortening the term is a bit like overpaying, it's far cheaper if you've got the cash. However, if the mortgage allows you to overpay, better to keep the mortgage long to give yourself flexibility, then make overpayments.

Try using the MoneySavingExpert Mortgage Best Buys comparison to see how changing the length of your mortgage term will affect your payments.

Quick questions

How long do you intend to stay in the property?

There's not much point picking a five-year fixed if you think you want to move in three years as there will undoubtedly be a charge for repaying early if you leave during the incentive period (either selling up or replacing this mortgage with a new deal from another lender).

Early repayment charges can be huge, as much as 5% of the loan, and will differ widely between products and lenders. See below for more on early repayment charges. and how to avoid them.

Are you planning on paying off a lump sum at any point?

Most mortgages allow you to overpay a certain amount a year (usually 10% of the outstanding debt) without triggering the early repayment charge. Check what your deal allows.

If you have plans to pay off a lump sum that exceeds the overpayment limit then you'll need to weigh up the costs of doing that if you're tied in. It may be better to wait to pay the lump sum once the incentive period is over.

If you have a strong opinion on what interest rates are likely to do, this will obviously influence your decision. Just be sure you can afford to get it wrong as even market experts can't guarantee what'll happen.

Watch out for early repayment charges

If you think about it, a fixed or discount deal is a special offer - a reduced rate from the lender in the hope that once the cheap price ends, you'll stick with it and maybe even pay more (sometimes you'll actually pay less).

To ensure you don't just chop and change your mortgage once a better rate comes along, many lenders impose an early repayment charge. Lenders aren't allowed to stop you repaying your mortgage, but they are allowed to penalise you for doing it early. The charge will apply if you:

  • Pay off the mortgage in full (eg, you inherit a pile of money and just want to clear the mortgage off; or you remortgage, meaning you get a replacement mortgage with another lender); or
  • Pay the lender back more than you're allowed to. Any payment over and above your normal, agreed monthly payment is called an overpayment. Most lenders allow you to overpay a certain amount, but breach this and it could cost you.

This is why it pays to decide on an incentive period that's right for you. If you end up having to move or sell the house during the term, the penalties to get out of your deal can be large.

Quick questions

How much are early repayment charges?

An early repayment charge can be 1%-5% of the amount you pay off early. Clear a Ј150,000 mortgage and you'll pay anything from Ј1,500 to Ј7,500. Overpay by Ј1,000 and it could cost you Ј10-Ј50 for the privilege.

But it varies, so check the small print. It'll be in the illustration (but check the mortgage offer as well, as the lender doesn't always get them to match as they should). The early repayment charge is usually a percentage of the amount you overpay. It's quite common to see the percentage charge reduce the further into the tie-in period you go.

For example, a five-year fixed deal may have an early repayment charge of 5% in year 1, 4% in year 2, and so on.

Not every deal has an early repayment charge. You can sometimes overpay without being stung, particularly on lifetime deals, and there have even been rare examples of fixed rates with no tie-in.

Am I free to move after the deal ends?

Once your fixed or discount deal ends, in most cases you are free, and you should consider switching the deal.

We say this because once your deal ends, you'll be shifted onto the standard variable rate, which is usually uncompetitive.

In recent times, some lenders' SVRs have been quite decent, so it's not always worth switching, particularly if your mortgage debt is low.

Still, good practice is to start looking a few months before your special offer ends to see if you can get a cheaper remortgage deal (remortgaging just means switching mortgage) as for every 1% of interest you cut per Ј100,000 of mortgage, that could be Ј80+ month saved. Full help in our Remortgage Guide .

What's an overhang?

One warning is that some products can have an 'overhang', otherwise known as an 'extended tie-in' or 'extended early repayment charge'. These last for a period after the special offer period, ie, when you're on the higher SVR. Cheeky, but we've seen it happen!

They were used by lenders in the past so they could offer really attractive low initial rates, knowing they would recoup some of the money later. Uninformed borrowers got a nasty shock when they moved onto the SVR and found they'd still have to pay a sizeable charge to remortgage. They are few and far between, but do check, and try to avoid them.

You might be okay with an overhang if it gets your costs down low at the start, when you're first buying. But you need to be sure it's good value overall and that you can definitely afford it when the rate goes up.

Remember, you'd be going on to the SVR, which the lender can move at any time. That means it could be higher than illustrated, so you need to be sure you could cope. You might enjoy the initial low rate but will you really be happy when the rate bumps up?

Can I take the mortgage with me if I need to move house within the term?

If you think you might move during the incentive period of the mortgage, you need to look for a mortgage deal that allows 'porting'. This just means that you can move the mortgage to another property without incurring an early repayment charge.

A deal that allows porting can be attractive if you want a long-term, low-rate incentive period, but aren't 100% sure you'll want to stick with the property for the length of the deal.

Not all mortgages are portable and allow you to move them to a different property. Even if your deal is portable, it doesn't guarantee the lender will let you move it. It can refuse your application to port for many reasons - for example, if it doesn't like your property, you can't prove your income, your income's changed or you're in arrears

Choice 4: Do I want my mortgage to be flexible?

Once you've got an idea of the key requirements for your mortgage, the next question is: do you want a mortgage that's more flexible?

This means getting functions that allow you to over-or underpay, and borrow money back. Sometimes flexible features are included in the cheapest mortgages already, which is an added bonus.

Other times, you might need to take a higher-rate product to get the feature you want. You'll need to weigh up what you definitely need, what depends on cost and what doesn't matter as you'll probably not use it.

The MoneySavingExpert Mortgage Best Buys tool will show you the top mortgages that fit your criteria, and will tell you if your chosen mortgage has any flexible features.

Flexible feature 1 – Can you, and should you, overpay?

Far more important than the others, is the most popular flexible feature - the ability to overpay. This just means paying more than your agreed monthly repayment – whether each month or just shoving a lump sum at your mortgage from time to time.

Overpaying can result in clearing the debt substantially quicker, so you pay less interest overall. The impact of this can be huge.

If you had a Ј150,000 mortgage over 25 years at 5% interest, your monthly repayments would be Ј880. Over the term, you'd pay Ј113,000 in interest. If you overpaid by Ј100 a month, you'd repay the mortgage four years and seven months quicker, saving Ј23,350 in interest.

Luckily, most mortgages allow you to make some form of overpayment. So you don't always need something special (as special usually costs more).

However, they usually restrict the amount of money you can overpay – typically 10% of the outstanding mortgage/year, or a fixed max amount each month (do more and there are harsh penalties). Less commonly, they might restrict when and/or how often you can overpay.

So you need to work out how much you're likely to want to overpay by, and when you're likely to want to overpay.

Timing your overpayment

Mortgage companies calculate how much interest you owe on the debt at different times. The vast majority do it daily, a few quarterly or yearly. You need to know how yours works so you can time your extra payments.

With daily interest the timing doesn't especially matter. You benefit the next day, so sooner is always better. However, it makes a huge difference if interest is charged annually – and middling if it's monthly or quarterly.

This is because mortgage overpayments will only count to reduce the interest you pay AFTER the calculation is made. Put it in at the wrong time and you'll miss out.

Say the amount you'll be paying in interest is worked out on December 31, then you need to make sure you pay the extra in before Christmas. Leave it until January and you lose the benefit of overpaying. You'll still be charged interest as if you hadn't made the overpayment until next 31 December.

Most mortgages these days are daily interest, but be sure to check.

Does the mortgage have a 'borrow back' facility?

If you're overpaying, a few lenders will allow you to get the overpayments back if needed - though they don't always shout about it, making it a hidden bonus.

If your lender allows you to do so, then you can effectively use your mortgage as a high-interest savings account. If you leave money in it temporarily, the net effect is the same as earning interest tax-free at the mortgage rate – very few savings accounts will beat that right now.

Flexible feature 2 - Can you take payment holidays?

Here, the lender will allow you to simply stop paying it when you want. But be careful. Lenders don't let you play hooky from the goodness of their hearts.

Some lenders insist you've overpaid first (so it's the same effect as the borrow-back). If they don't, then you'll pay for it as the interest continues to be added to your loan and you're not clearing anything.

Typically, borrowers taking a 'holiday' arrange to miss one or two payments, and their monthly payments are recalculated to spread the cost of those missed payments the rest of the life of your loan – in other words, your repayments will go up.

In addition, there could also be an extra penalty or administration charge on top.

Be careful: You can't just decide to take a payment holiday because it's a feature of your mortgage, always arrange it with your lender first.

If you don't, it'll hit your credit file and look like you've missed payments willy-nilly. This will seriously damage your credit score and your remortgage chances in the future.

Get Martin's Free Money Tips Email!

For all the latest deals, guides and loopholes - join the 10m who get it. Don't miss out

Source: www.moneysavingexpert.com

Category: Bank

Similar articles: