Understanding the Different Types of Mortgages
With so many different types of mortgages available, the legal and financial jargon, interest rates and small print, it is easy to feel lost and overwhelmed.
In this guide, Compare My Move will talk you through the different types of mortgages available and break down what each of them offers, giving you a clearer idea of which mortgage is best for your needs.
A mortgage is a loan taken out to buy a property or land. It is paid back with interest over a “term”, normally 25 to 35 years. The mortgage will be secured against the value of the property until the full amount is paid off.
If you don’t keep up with your mortgage repayments, the lender can potentially repossess your home. Make sure you work out how much mortgage you can afford to borrow.
The number of people using mortgages to buy a home is increasing year on year. Data from UK Finance shows the number of completed mortgages for first-time buyers and those moving home increased from 2.8% to 4.2% in October 2019, compared to the previous year.
Once you have found a property to buy and received a mortgage offer, your conveyancing solicitor will liaise with your mortgage provider to complete the purchase.
With a fixed-rate mortgage, the interest rate on your mortgage, and therefore your monthly payments, will be fixed for a set amount of time, normally two, three or five years. For example, a lender might offer a five-year fixed rate at 2.5%.
When the fixed-rate 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.
The big advantage of a fixed-rate mortgage is security. You will know what your mortgage payments will be each month for a certain amount of time which can help you budget. 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 this.
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 payments will become more expensive. Most people remortgage to a better deal at this point.
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.
Variable Rate Mortgages
With a variable rate mortgage, the interest rate you pay, and therefore your monthly payments, can potentially go up or down each month.
This might be due to changes to the Bank of England base rate, or your lender’s standard variable rate (SVR). There are different types of variable rate mortgage.
There are different types of variable rate mortgage. These include:
- Your lender’s standard variable rate (SVR)
- Discount mortgages
- Tracker mortgages
- Capped rate mortgages
Your 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.
While some lenders offer mortgages at the SVR, the most common reason you’ll pay the SVR is because it is the go-to rate at the end of a fixed-rate deal. For example, a mortgage might be fixed at 2% for two years then revert to the lender’s SVR.
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 save money by remortgaging to a better deal.
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.
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.
The interest rate on a tracker mortgage 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 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 ceiling, or cap, beyond which your payments can't rise.
These capped rates usually only last a certain amount of time, at which point you will be transferred to the lender’s SVR.
Capped rate mortgages are less common than discount mortgages or tracker mortgages. They tend to be more expensive than other types of variable rate mortgage.
What is an Offset Mortgage?
An offset mortgage is a type of flexible mortgage. Offset mortgages can be fixed-rate or variable rate.
Offset mortgages 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 can be a good bet if you have a high savings balance. However, offset mortgages tend to be more expensive than other types of mortgage.
What is an Islamic Mortgage?
An Islamic Mortgage, or Sharia-compliant mortgage, adhere to Sharia law. Paying or receiving interest is forbidden under Sharia law.
There are two types of Sharia mortgage:
Ijara: 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: 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.
In theory, anyone can take out an Islamic mortgage but, in practice, they are normally only taken out by practicing Muslims.
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). It is a type of equity release and enables homeowners aged 55 or over to release the equity in their home without selling up.
Lifetime mortgages aren’t relevant to first-time buyers and are normally used in retirement.
This type of mortgage might affect what you leave as an inheritance. This is because once you're gone, the house will be sold to pay for the accumulated interest from the mortgage.
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. This is more likely to happen with a bigger mortgage.
- You could be buying a house sooner than if you took out a mortgage which required a 10% deposit.
- It will potentially take you longer to pay off or mean higher monthly repayments and you will pay more interest to the bank.
- The risk of falling into negative equity.
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