Written by Emma Lunn
Taking out a mortgage is one of the biggest financial transactions you’ll make, so it’s important to get it right.
This guide explains the different types of mortgage available, what to look out for, and the fees you might have to pay when you take out your loan.
Most people take out a capital and interest mortgage, where the monthly repayment is made up of an interest payment plus a payment towards the outstanding debt. At the end of the mortgage term, the borrower owns the property outright.
The alternative is an interest-only mortgage. This is where no payment is made against the capital debt, so that, at the end of the mortgage term, the initial debt is still outstanding.
The intention here is that the debt will be cleared using funds from elsewhere, such as an investment plan, or the sale of the property.
Interest-only mortgages are less common than in previous years because weak investment markets have made it difficult to build up sufficient funds to clear the debt.
There is also the risk that, if the property’s value falls, selling it to repay the debt ceases to be a viable solution.
Mortgages generally fall into two main categories, determined by how the interest is charged:
- Fixed interest rate
- Variable interest rate
Fixed rate mortgages
A fixed rate mortgage has a set rate of interest for a stated period of time, enabling you to guarantee your mortgage payments. Your payments won’t change, regardless of what happens to interest rates elsewhere, such as the Bank of England base rate.
This makes it easier to budget, because you know each month how much your biggest household expense will be.
Two or five-year fixed rate mortgages are the most common but some lenders offer 10-year fixed rates.
Variable rate mortgages
If you have a variable rate mortgage, the interest rate can change at any time. This can make it more difficult to budget with certainty for your mortgage payments.
Variable rate mortgages themselves come in various forms such as:
- Standard variable rate
Standard variable rate (SVR) mortgages
All lenders have a standard variable rate (SVR) of interest. Some mortgages are charged at this rate from the beginning while other deals (such as fixed rate mortgages) revert to the SVR after a period of time.
The lender can change its SVR at any time, although the majority of movements in the rate will be in line with changes to the Bank of England base rate.
Discounted mortgages offer a discount off the lender’s SVR for a set period of time. For example, you might pay the SVR minus 1% for two years.
Some lenders offer ‘stepped discounts’. For example, the discount might be 1% in the first year, 0.75% in the second year, and 0.5% in the third year.
The interest rate on a tracker mortgage moves directly in line with another interest rate – normally the Bank of England’s base rate.
For example, the rate you pay on a tracker mortgage might be ‘base rate plus 1%’. So, if the base rate is 0.25% you’ll pay 1.25%. If the base rate goes up by 1 percentage point, you’ll pay 2.25%.
With some tracker mortgages, the arrangement lasts for a given number of years. Alternatively, you can remain on a tracker for the full duration of the mortgage.
Offset mortgages allow borrowers to ‘offset’ their savings and current account balance against their mortgage and only pay interest on the difference.
For example, if you had a £100,000 mortgage and offset £20,000 of savings against it, you’d only pay interest on £80,000.
A flexible mortgage enables you to change or vary your monthly payments depending on certain conditions being met.
For example, you may be able to overpay large amounts without penalty or take payment holidays. Most flexible mortgages also allow you to offset your savings.
A cashback mortgage pays you a cash lump sum on completion.
If you want to borrow to buy a property to let to tenants, you’ll need a buy-to-let mortgage.
Buy-to-let mortgages can be fixed or variable rates, have different lending criteria to residential owner-occupier mortgages and usually carry higher interest rates.
What to watch out for
Loan-to-value (LTV) ratio
The loan-to-value (LTV) ratio refers to the proportion of the property’s value you’re borrowing as a mortgage. For example, if you put down a 10% deposit and borrow 90% of the property’s value, the LTV will be 90%.
Mortgage deals all come with a ‘maximum LTV’, typically between 60% (ie, a 40% deposit) and 95% (5% deposit). In general, the lower the LTV, the better the interest rate you’ll be offered.
The term is the number of years over which you will repay your mortgage. Mortgage terms can be anything from five to 40 years but 25 years is standard.
The loan-to-income (LTI) ratio is how many times your annual income you can borrow as a mortgage.
It’s one, but not the only way, lenders assess the affordability of your loan. As a general rule, it’s difficult to borrow more than four-and-a-half times your income.
Before they offer you a mortgage, lenders look at your income and outgoings to assess how much you can afford to pay. The affordability assessment will include ‘stress testing’ your ability to pay in the future, if rates rise, or your income drops.
As well as an interest rate, most mortgages come with a number of fees. These include:
- Booking fee: A fee for booking, reserving or applying for a mortgage.
- Arrangement fee: A fee for setting up the loan. The arrangement fee can be either a flat fee or a percentage of the loan amount.
- Valuation fee: A fee to cover the lender’s cost of conducting a basic survey to check the property is adequate security for the mortgage.
- Legal fees: A fee to cover the cost of the lender’s conveyancing work.
- Mortgage exit fee: A fee to cover the admin work involved when you redeem (pay off) your mortgage.
- Early repayment charges (ERC): A charge applied if you want to pay off the debt, move house, or remortgage before the end of a fixed or tied-in period.
Doing the sums
Mortgage fees can mean that a cheap interest rate doesn’t necessarily mean a cheap mortgage.
To work out the best deal you need to calculate exactly how much you’ll pay in total (monthly repayments plus fees) over the time period for which you’re tied into a mortgage product.
For example, say you wanted to borrow £200,000 over 25 years on a two-year fixed rate mortgage. One lender might offer an interest rate of 1.5% with total fees of £1,500. This would cost a total of £20,697 over two years (£19,197 in monthly payments plus £1,500 in fees.)
Another lender might charge a rate of 1.75% but no fees. The total cost over two years would be £19,766. That’s £931 cheaper than the mortgage product with a lower interest rate.
Any cashback should also be factored into these calculations. A cashback mortgage with a high interest rate or high fees may work out more expensive than non-cashback options.
There are numerous mortgage products available and it’s important to find the right one for your circumstances.
We work with fee-free mortgage broker London & Country, which offers a telephone-based advice service that will help you find the right mortgage.
You can call London & Country on 0800 170 1943.