How to choose a mortgage

Published:
26 May 2010
Topic:
News,Money,Mortgages

If you are totally confused by mortgages and unsure how to work out which deal is the most suitable don't worry, you're not alone.

It's a hugely complex market. Here we explain the basics so that you'll be better informed when it comes to making the decision about what type of mortgage to go for.

What are the options?

Broadly speaking there are two types of mortgage deals: fixed and variable rates.

Fixed rates

As their name suggests, fixed rate mortgages charge a set rate of interest for a certain period of time - often two, three or five years (you can fix your mortgage rate for longer but most people tend not to for reasons that will be explained).

Once the fixed rate period ends you will move onto a variable rate - at this point it is usually worth remortgaging onto a new deal.

Advantages: The main advantages of a fixed rate mortgage is that you know exactly what your mortgage payments will be and you are protected from any increases in interest rates during the fixed term. Fixed rates therefore tend to be popular with those who need to budget carefully or who just prefer the peace of mind an unchangeable rate of interest gives.

Disadvantages: You are usually tied into the mortgage throughout the fixed term and will be charged an 'early redemption charge' (ERC) if you redeem your mortgage during that time. It is for this reason that most borrowers tend not to fix their mortgage for longer than five years because so much can change - interest rates may plummet (as we saw between October 2008 and March 2009) leaving you stuck on an uncompetitive rate, or your circumstances may change meaning you need to get out of your mortgage deal.

Variable rates

Again, the clue is in the name, but the amount you pay on a variable rate mortgage can move up or down. This usually happens if there is a change in the main Bank of England base rate. However, it can vary depending on what type of variable rate deal you have - tracker or discount.

Trackers: If you have a tracker your mortgage rate is set at a fixed margin to Bank rate and should therefore move up and down in line with interest rate changes. For example, the rate may be pegged at 2.00% above base rate. With base rate currently at 0.5%, this means you'd be paying a mortgage rate of 2.50%.

Trackers are available over different terms. Some are lifetime deals which means you are on that margin until the mortgage is repaid. These are great if you don't want the hassle of remortgaging every few years. They also tend to be very flexible as most don't have ERCs which means you can switch to another deal at any time without having to pay a penalty for doing so.

Others have set terms - often two, three or five years - and an ERC usually applies during that time. However, the rates tend to be lower than those on lifetime trackers. Once the term comes to an end you will move onto a higher rate although you can probably remortgage at that point without incurring a penalty.

Discounts: A discount mortgage, on the other hand, works slightly differently. Rather than being linked to Bank rate, the rate you pay is linked to your lender's standard variable rate (SVRs). Providers often change their SVRs if there is an increase or decrease in bank rate, but they don't have to - any change is at their discretion and we have seen an increasing number of lenders decide not to pass on the recent interest rate cuts to their SVRs.

Of the 20 largest residential mortgage lenders, only Lloyds TSB/Cheltenham & Gloucester reduced its SVR by the full 4.50% when the Bank of England cut base rate from 5.00% to 0.50% between October 2008 and March 2009. To see how other lenders reacted to the interest rate reductions take a look at our article 'How has your lender responded to the rate cuts?'.

The discounted rate normally applies for a set term - often two, three or five years - and during that time you will be tied in and face paying an ERC if you want to redeem the loan. Once the discounted period ends you will probably move onto the SVR but should be able to remortgage without penalty.

Advantages: The main advantage of a variable rate mortgage, tracker or discount, is that you should benefit from lower monthly repayments if interest rates fall.

Disadvantages: But the main disadvantage of a variable rate mortgage is that your monthly repayments could also go up if interest rates increase.

Recently those with variable rate mortgages have been better off than those with fixed rates because of the fact base rate plummeted by 4.50% in less than six months and have remained unchanged at 0.5% since March 2009. But you only have to think back to 2007 when interest rates were rising to understand the potential drawback of a variable rate deal.

And with base rate at a historic low, we know the next move will be upwards. We just don't know when that will be. If money is tight and you couldn't afford for your mortgage payments to rise, a variable rate mortgage probably isn't the best option.

Also, as many of those with variable rate mortgages have discovered to their cost in recent months, even if interest rates do come down you may not benefit in full.

Generally, trackers are more transparent than discounts because the rate you pay is directly linked to base rate. But one quirk of some tracker deals is that they come with a 'collar' which means that the lender does not have to pass interest rate cuts on if the rate falls below a certain level. Yorkshire Building Society for example, has a 3% collar on many of its tracker products. Consequently, borrowers on those deals didn't see the full reduction in their monthly payments when base rate fell from 5.00% to 0.50%. It is therefore vital that you read the small print of any mortgage deal before applying.

Things to watch out for

Minimum deposit

The root cause of the financial crisis was that banks and building societies lent over-zealously. Many borrowers over-stretched themselves and have been unable to keep up with their mortgage payments. As a result, the lenders have been saddled with 'bad debts'.

Consequently they are now much more nervous about who they will lend to with many restricting their best mortgage deals to low-risk borrowers who have a sizeable amount of equity in their property.

The days of being able to get a mortgage without any deposit are over - and unlikely to return. You basically need a deposit of at least 10% if you have any hope of getting a new mortgage, and lenders are demanding even larger deposits on many of their deals.

Some of the lowest mortgage rates are only available to those with 40% to put down, although if you have a 25% deposit you should have a fair amount of product choice.
It is not only first time buyers who are struggling in the 'new mortgage world'. Many of those who bought their homes a few years ago with only a small deposit are finding they can't remortgage. Last year's house price falls mean they have not built up the equity they expected and for some the value of their outstanding mortgage is greater than the value of their home (this is called negative equity). If you are in this position there is no need to panic.

You may not be able to remortgage when your fixed or discounted rate comes to and end but this does not mean you will be without a mortgage - you will move on to your lender's SVR or a long-term tracker rate, so as long as you can keep up with your monthly payments, your home will not be at risk. You then just need to wait until you are able to switch to another deal, either because lenders relax their criteria again or house prices pick up meaning you have more equity in your home.

SVRs are usually significantly higher than short term mortgage rates, but because of the recent interest rate cuts, there is little difference at the moment between many SVRs and the rates on new mortgage deals, so it's not the end of the world if you can't remortgage.

Arrangement fees

Interest isn't the only thing you pay on a mortgage. With most deals you have to pay an arrangement or application fee just to set the loan up. These costs have been rising in recent years and a charge of about £1,000 is not uncommon.

Most deals charge a flat fee so the amount you pay is the same regardless of the amount you are looking to borrow. However, some lenders charge a percentage fee, say 1% of the loan size. So if you are wanting to borrow £100,000, you would pay a £1,000 arrangement fee, but if you need a £500,000 mortgage the fee would be £5,000.

Percentage fees are used by lenders as a way of offering lower headline rates which may make a product look very attractive. However, once you factor in the fee, the deal may not be as competitive as it initially appears. When comparing mortgages you therefore need to work out the total cost of the loan, including fees, over the period of the fixed or variable rate term. If you are unsure about how to do this, an independent mortgage adviser will be able to help.

Tip: Generally speaking, unless you are borrowing a small amount, a deal with a flat fee is likely to prove better value than a product with a percentage fee.

Exit fees

When you come to remortgage, your current lender will probably charge an exit fee. This is supposed to cover the cost of closing your mortgage account. The amount will depend on the lender, but it will be stated on your mortgage offer.

Other fees

Lenders require a valuation survey when considering a mortgage application as they need to know what the property is worth. There will also be legal fees to cover the conveyancing costs.

If you are remortgaging it's often worth going for a deal that includes free legal and valuation work for remortgages.

Extended ERCs

It is usual for lenders to impose a penalty if you redeem your mortgage within the fixed or discounted term, but watch out for products that continue to tie you in once that period has come to an end. Such deals often have really low initial rates, making them appear highly attractive but the sting in the tail is that the rate jumps - leaving you stuck on a much less competitive rate for another few years once the introductory period ends.

Key points to consider

So before you apply for a mortgage you need to think about:

  • Whether you'd prefer the security of a fixed rate or are happy to take a gamble and go for a variable rate; 
  • The length of time you are prepared to be tied in for; 
  • What size deposit you are able to put down.

And then remember to check:

  • How much the fees are; 
  • Whether or not an ERC applies and if so, how long for.

Please note: Any rates or deals mentioned in this article were available at the time of writing.

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