Understanding the Different Types of Mortgages

Written by Adele MacGregor Reviewed by Emma Lunn

19th Feb 2020 (Last updated on 24th Nov 2022) 12 minute read

COVID-19 and Mortgages

As a result of the impact of Covid-19 and the nationwide lockdown on the economy, the UK has officially fallen into recession for the first time in 11 years. The events of 2020 have seen the property market has taken an unexpected hit, impacting buyers, sellers and the industry across the board.

In response to the downturn, many lenders have changed or reduced their mortgage products, in addition to some -but not all - granting mortgage offer extensions. Keep all this in mind when looking into what mortgage is best for you and your circumstances. If you are uncertain going forward, speak to your current lender or hire a mortgage broker who can help you find the solution that works for you.

What are the Types of Mortgages Available in the UK?

With so many types of mortgages available, not to mention the legal and financial jargon, interest rates and small print, it is easy to feel lost and overwhelmed.

Below we’ve listed the different types of mortgages on the market today, including popular options such as fixed-rate and variable, in addition to specialist mortgages like Islamic and Guarantor mortgages. In this article, we will give an overview of which one so that you can get an idea of which mortgage is best for you.

• Variable Rate Mortgage including Discount, Tracker and Capped Rate Mortgages

• Fixed-Rate Mortgage

• Interest-Only Mortgages

• Offset Mortgage

• Lifetime Mortgages

• 95% Mortgages

• Cashback Mortgage

• Guarantor Mortgages

• Islamic Mortgages

What is a Variable Rate Mortgage?

With a variable rate mortgage, the interest rate of the mortgage is not fixed. In this case, the interest rate you pay, and therefore your monthly payments, can potentially go up or down each month.

The interest rate will be the lender’s Standard Variable Rate (SVR) which is influenced by the Bank of England base rate. This type of mortgage is not recommended for those who want to know exactly how much they are paying each month. A variable rate mortgage makes it harder to budget and plan financially, however, unlike a fixed-rate mortgage, you will benefit when the lender’s SVR drops. Be aware that your payments will increase if and when the lender’s SVR rises.

There are several different types of variable rate mortgage available and these include:

• Your lender’s standard variable rate (SVR)
• Discount mortgages
• Tracker mortgages
• Capped rate mortgages

What is a Lender’s Standard Variable Rate?

Each mortgage lender will have a standard variable rate (SVR). The lender can change this rate whenever it wants to, although most changes are in line with changes to the Bank of England base rate.

The most common reason you’ll be on a lender’s SVR is at the end of a fixed-rate or other mortgage deal. For example, a mortgage might be fixed at 2% for two years then revert to the lender’s SVR, which is usually higher.

In most cases, the SVR will be more than you were paying on the fixed-rate and your payments will go up. However, you can potentially save money by remortgaging your house in favour of a better deal.

To find out more visit: What Is a Standard Variable Rate Mortgage?

Discount Mortgages

A discount mortgage has an interest rate that is set a certain amount below the lender's standard variable rate (SVR). For example, the rate might be the lender’s SVR minus 1%. So if the SVR is 5%, you’ll pay 4% interest. This will usually be for a set period of time; for example, two or five years.

The interest rate can change if the lender changes the SVR. In the example above if the SVR was upped to 5.5%, you’d pay 4.5% interest. But if it was reduced to 4.5%, you’d pay an interest rate of 3.5%. This means your mortgage payment can change from month to month. This can make it tricky to budget and plan financially so if this is a concern, a Discount Mortgage may not be right for you.

A discount rate may have a “collar” – a limit to how low the rate can fall below a certain percentage, limiting how much discount you can actually benefit from. Once the discount period ends, you will automatically be transferred to your lender’s SVR. Discount mortgages allow you to benefit from any reductions in your lender’s SVR – but you’ll pay more if the rate increases.

Tracker Mortgage

A Tracker Mortgage is a mortgage with an interest rate which tracks the Bank of England base rate. For example, the rate might be the base rate plus 1%. So if the base rate is 0.75%, you’ll pay 1.75%. The base rate is set by the Bank of England’s Monetary Policy Committee each month. If the base rate is increased, your mortgage payments on a tracker mortgage will go up. If it’s decreased, your mortgage payments will go down. This means your mortgage payments can change from month to month. This can make it tricky to financially plan and create a monthly budget.

Some tracker mortgages are for a certain amount of time, e.g. two or five years before reverting to the lender’s SVR, while others are for the entire term of the mortgage (known as a “lifetime tracker”).

Capped Rate Mortgages

A capped rate mortgage is a type of variable rate mortgage, but with one key difference: it has an interest rate cap, meaning your payments can't increase above a certain amount.

Usually, these capped rates only last a certain amount of time, at which point you will be transferred to the lender’s SVR. These mortgages are less common than discount mortgages or tracker mortgages and tend to be more expensive than other types of variable-rate mortgages.

What is a Fixed-Rate Mortgage?

A fixed-rate mortgage means that the interest rate on your mortgage, and therefore your monthly payments, will be fixed for a set amount of time. This is normally two, three or five years. For example, a lender might offer a five-year fixed rate at 2.5%. During that period, you will not pay more or less than this amount.

When the fixed-rate period ends, you’ll normally be moved to your lender’s standard variable rate (SVR). This will probably be a higher rate and your monthly payments will become more expensive. At this point, most people will remortgage for a better deal.

If you want to remortgage or move house before a fixed rate ends, you will normally have to pay early repayment charges (ERCs). These vary between mortgage lenders and different products and can be expensive. There are other costs involved such as remortgage solicitor fees, arrangement fees and mortgage broker fees.

The big advantage of a fixed-rate mortgage is the security it offers homebuyers. You will know what your mortgage payments will be each month for a fixed amount of time. This can help you plan and budget during your fixed-rate time period. This is especially an advantage if you are taking out a mortgage whilst on a zero-hour contract.

With a fixed-rate mortgage, your payments won’t be affected by changes to the Bank of England base rate. So if the base rate goes up, your payments stay the same. On the downside, if the base rate goes down you won’t benefit from a lower interest rate.

What Is an Interest-Only Mortgage?

An interest-only mortgage, as the name suggests, is a mortgage where your monthly payments cover just the interest on the mortgage. This means that you will not reduce the amount you owe. As a result, your repayments will be lower but you will still owe the same at the end of the term as you did when you took out the mortgage. In order to own the property, you must repay the whole balance at the end of your mortgage term.

This can be done using a lump sum, such as an inheritance or pension withdrawal or by using a repayment vehicle, which includes any kind of savings plan like an ISA, investment fund or pension. You are also able to sell the property to pay back the mortgage.

To find out more visit: What Is an Interest-Only Mortgage

What is an Offset Mortgage?

An offset mortgage is a type of flexible mortgage which can be a fixed-rate or variable rate. These work by linking your savings accounts (and sometimes your current account too) with the same lender to your mortgage. You still pay monthly instalments, but you’ll be paying interest on a lower amount.

For example, if you had a £100,000 mortgage and £20,000 in a linked savings account, you’d only pay interest on £80,000. This means you could either pay a reduced amount each month or pay the normal amount with the extra money acting as an overpayment. Making overpayments will mean you pay off your mortgage quicker and reduce your total interest bill.

Offset mortgages have their advantages if you have a high savings balance. However, they tend to be more expensive than other types of mortgage.

What is a Lifetime Mortgage?

A lifetime mortgage is a type of mortgage you can take out when you own your home outright (e.g. when you have paid off your mortgage in full). It is a type of equity release and enables homeowners aged 55 or over to release the equity in their home without selling up.

These are normally utilised in retirement. Be aware that this type of mortgage might affect what you leave as an inheritance.

What is a 95% Mortgage?

Saving for a deposit is one of the biggest hurdles for first-time buyers, so a smaller deposit could get someone on the property ladder far quicker. However, buyers run the risk of falling into negative equity with a 95% loan, which happens when the value of your home falls below the value of your mortgage. It will potentially take you longer to pay off or mean higher monthly repayments and you will pay more interest to the bank.

It is also worth noting that due to the effects of COVID-19 on the economy and the housing industry, banks were initially more reluctant than ever to offer these mortgages and some did not offer them at all. However, as part of the budget announcement on March 3rd 2021, it was announced that the government will be offering a guarantee for lenders to encourage them to offer 95% mortgage. This will fun from April 2021 until the end of 2022, with lenders such as Lloyds, Natwest, Santander, Barclays and HSBC are signed up.

The scheme is designed for any "creditworthy" households struggling to save for a higher deposit and will apply for standard residential mortgages. Second homes and buy-to-lets will not apply. Moreover, the property must cost £600,000 or less and the mortgage must be on a repayment basis, not interest-only.

To find out more read: What are 95% Mortgages?

What is a Cashback Mortgage?

As the name suggests, when you take out a Cashback Mortgage, you are given a cashback lump sum. This may be a proportion of the amount you are borrowing, for example, a small percentage of the mortgage. In other cases, it could be a fixed amount. You receive this cashback on completion.

The advantage of a cashback mortgage is that a lump sum after completion can help with the cost of furniture, repairs to the new home and so on which can be a huge benefit, especially for those buying their first home. However, these mortgages often come with a higher interest rate, so make sure this is the most financially sound deal for you and your finances before proceeding.

Guarantor Mortgages

A Guarantor Mortgage is a mortgage where either a parent or close family member (such as a grandparent) takes on a proportion of the risk of the mortgage by acting as a guarantor. They will be required to provide savings or their home as security against the loan. If you fail to make your agreed mortgage repayments, your guarantor is agreeing to cover the cost of the mortgage payments.

Although this can be an ideal way for first-time buyers to get on the property ladder quicker than saving for a deposit - and potentially allows them to borrow more - the guarantor will be liable for any shortfall if the property has to be repossessed by the lender in the event that mortgage payments are not met.

To find out more visit: Guarantor Mortgages Explained

What is an Islamic Mortgage?

An Islamic Mortgage, or Sharia-compliant mortgage, adheres to Sharia law under which paying or receiving interest is forbidden. In theory, anyone can take out an Islamic mortgage but they are normally only taken out by practising Muslims. There are two types of Sharia mortgage which are:

Ijara: This is where the bank purchases the property you want to buy and leases it to you for a fixed term at an agreed monthly cost, after which the full ownership of the property is transferred to you.

Murabaha: In this case, the bank buys the property on your behalf and sells it to you at a higher price, paid in equal instalments over a fixed term.

Why Is It Important to Get a Good Mortgage Deal?

For the majority of people, buying a property is one of the biggest financial decisions they will make in their lifetime. The Financial Conduct Authority found that the outstanding value of all residential mortgages loans was £1,513.3 billion at the end of 2020 Q2, 3.2% higher than a year earlier.

Depending on your agreement with your lender, this is a loan you will be paying back for a number of years - even decades - so it is essential that you choose a mortgage product that is right for you.

A “good” mortgage deal is exactly that - the mortgage that best suits your circumstances. What may be an ideal product for one person, may not suit someone else. This is why it is crucial that you undertake as much research as possible before agreeing to a mortgage deal. It is also why many budding homeowners enlist the services of a mortgage broker.

If you opt for a deal which is financially unsuitable, you may find yourself struggling with repayments. Remember that if you fail to make your monthly mortgage repayments, the lender can potentially repossess your home.

Learn More About Mortgages

This has been part of our mortgages and deposits guide. The next article in this series is all about mortgage valuations. You will require a valuation as part of the process of applying for a mortgage. For further information, read what is a mortgage valuation?