There are many different types of mortgages on the market, which is terrific - it means you have options.
However, choosing between them is often quite complicated. Each type of mortgage comes with its own features, some more suitable for certain lifestyles and circumstances than others. How do you know what suits you? Do you want an interest-only or repayment mortgage? Should you go for a variable rate or fixed rate? Do you need any special features? It’s all rather confusing and can take a while to fully understand.
You’re often bombarded with many different mortgage products – discounted, fixed, tracker, flexible/offset, including those aimed at specific sections of the market, e.g. first-time buyers, home movers, people looking to remortgage, and buy to let – which can make the process seem overly complicated.
But you don’t need to be an expert on the different mortgage types right away; you just need somewhere to start.
We’ll help you answer the following questions:
- Do you want a repayment or interest-only mortgage?
- What other special features might appeal to/suit you?
- What type of interest rate option would suit you – tracker, discounted, fixed?
The Topics Covered in this Article Are Listed Below:
Repayment or Interest-Only Mortgage?
Before you settle on what type of mortgage product you want, you need to decide how you’re going to repay the mortgage you’re about to take out. In other words, you need to choose between a repayment or interest-only mortgage. Essentially, you decide whether you want to make monthly repayments comprising both interest and capital, or whether you want to only pay the interest on the money you’ve borrowed and repay the loan later by lump sum payments or possibly even by selling the property.
Repayment Mortgages
With a repayment mortgage, your monthly repayments cover both capital and interest on the loan. No other repayment vehicle is needed.
Pros of Repayment Mortgage
- A repayment mortgage is simple, straightforward and easy to understand
- You don’t have to worry about paying it all back in one go
- A repayment mortgage avoids the risk of investing in the stock market for your repayment vehicle
- As long as you maintain your full mortgage payments for the full term, your mortgage is guaranteed to be cleared at the end
Cons of Repayment Mortgage
- You can’t benefit from a potential rising investment which is affected by the stock market, like a pension or ISA
- When remortgaging, those who previously chose a repayment mortgage sometimes select another, long term repayment mortgage to keep the initial monthly costs down. This means that the overall total period of your mortgage could increase over time, which will increase your total mortgage cost
Interest-Only Mortgages
With an interest-only mortgage, you only make interest payments each month; your outstanding mortgage balance doesn't decrease bit by bit like with a repayment mortgage. Instead, you pay back the outstanding mortgage balance at the end of the mortgage term via a repayment or investment vehicle.
Pros of Interest-Only Mortgage
- You can choose from a variety of appropriate investment vehicles, some of which can have tax advantages
- Should you move or remortgage, your investment vehicle can usually be reallocated to the new mortgage (we always recommend speaking to an investment adviser if this is a route you want to consider)
Cons of Interest-Only Mortgage
- Unlike a repayment mortgage, your total amount of debt doesn’t reduce over time
- There’s no guarantee that your chosen investment vehicle will grow sufficiently to repay your loan (although you can usually top up your contributions to investments as you go along if a shortfall looks likely. You can also approach your lender to see if you can convert some or all of your mortgage to repayment to cover any investment shortfalls)
- Lenders who permit interest-only mortgages will only do so up to certain LTV limits - currently 75% - 85% maximum LTV)
The Different Types of Mortgage Interest Rates
Once you've decided whether to make monthly payments on the capital or not, you need to turn your mind to interest rate options. There are several different types of interest rate products that lenders offer. Each has its own advantages and disadvantages, but these are subjective. What you see as a disadvantage may be beneficial to someone else. The mortgage type you choose ultimately depends on whether it fits your current and future needs.
SVR (Standard Variable Rate)
The simplest - and original - form of interest rate product is one which sets its interest rate according to the lender's standard variable rate, or SVR. The SVR is the background rate that the lender charges interest at. They set it themselves and if the Bank of England increases the base rate then lenders are likely to increase their SVRs in line. It’s important to note that because the lender can set their SVR at whatever level they like, they can also increase or decrease it by whatever margin they choose, even if it’s not necessarily in direct line with any change from the Bank of England.
You wouldn't choose an SVR mortgage deal when you take out a mortgage. Most borrowers are automatically transferred onto their lender's SVR once their initial introductory rate period ends. Normally, you would arrange a remortgage up to 6 months before the end of your introductory rate to avoid going onto your lender's SVR. The only time you would usually choose not to remortgage but to go onto your lender's SVR is if you were approaching the end of your mortgage term and it wouldn't be worth remortgaging.
Pros of SVR
- SVRs usually have no early repayment charges
Cons of SVR
- The unpredictability of interest rate movements makes it hard to plan your finances
- The costs of your mortgage may rise rapidly if interest rates go up
- SVR rates tend to be significantly higher than any introductory rates
Discount Rate
A discount rate mortgage offers a reduction or discount of a set amount off the lender's standard variable rate. If the SVR changes, the rate you pay will fluctuate in line with that change but at the same level of discount, e.g. 0.5% below SVR.
Usually, a greater discount means a shorter period of discount. After the reduced rate ends, the loan normally reverts to the lender's SVR. At which point your payments will increase as the discount is removed.
Pros of Discount Rate
- Discount often have lower initial payments
- You can make savings if your SVR falls
- They're flexible
Cons of Discount Rate
- There's the risk of the lender's SVR increasing which will affect your payments
- It's more difficult to predict future payments
Fixed Rate
A fixed rate is a set rate of interest for a set period of time. Once that period ends, the rate reverts to the lender’s SVR. Fixed rates are available for many different lengths of time, e.g. 2, 3, 5, 10 years and sometimes longer.
Fixed rate mortgages tend to be very competitive, due to how popular they usually are. Lenders have to compete for your business so they tend to offer as low a range of rates as they can, which ultimately gives you better options to choose from.
Pros of Fixed Rate Mortgage
- A fixed rate won’t change during the specified period, so you know exactly how much your payments will be for that time
- A fixed rate can help you budget more effectively
Cons of a Fixed Rate Mortgage
- Fixed rate mortgages often have an early repayment charge
- If the Base Rate drops your fixed rate won’t; this may prove more expensive than a discount or tracker
Tracker
A tracker rate moves automatically in line with the Bank of England’s base rate by a set margin that usually remains the same for the initial product period. It’s unaffeted by changes in your lender’s SVR.
Tracker rates often track the Bank of England’s base rate by a certain percentage - e.g. the base rate plus 0.5% for 2 years or even the full term of the mortgage.
Many tracker products also offer flexible terms and are useful if you want to benefit from falling interest rates. However, it’s important that you’re certain you could afford any increases should the base rate rise.
Pros of Tracker Rate
- A tracker rate allows you to immediately benefit from any reduction in the Base Rate
- They’re also sometimes a bit cheaper than fixed rates
Cons of Tracker Rate
- If the Base Rate rises, so will your tracker rate - and by the same margin of increase
- Tracker rates lack the security of the fixed or capped rate mortgages
Other Types of Mortgage Features
As well as being one of the above interest rate types, some mortgages products include other features.
Cashback
There was once a specific type of mortgage product called a cashback mortgage. This was where a lender offered a significant percentage of the loan amount as cash paid on completion. These mortgages were usually on SVR for the first few years - at least. But now, cashback is often a lot smaller in size and is an added benefit of other mortgage types, liked a fixed rate or tracker mortgage. When you take out a mortgage with cashback, you receive an upfront lump sum. The lump sum used to be a fixed percentage of your total mortgage, but now it’s a set lump sum that’s usually between £250 - £1,000, depending on the lender and deal on offer. Modern cashback benefits are generally to pay for things like conveyancing fees or surveys costs.
Pros of Cashback Mortgage
- A lender that covers the conveyancing fees will choose a solicitor for you, whereas those that offer cashback give you the freedom to choose whichever solicitor you like and, as you’re paying, you may have more control over that side of the transaction
Cons of Cashback Mortgage
- You may miss out on having part of the process arranged for you, like conveyancing (however this needn’t be a problem if you use a mortgage broker like John Charcol as we can find you a solicitor or liaise with one you have in mind)
Flexible Mortgages
A flexible mortgage - also known as a droplock mortgage - is a discount or tracker mortgage that comes with the option to switch to a fixed rate with the same lender at any point during the initial period, without paying any early repayment charges.
Pros of Flexible Mortgage
- A flexible mortgage allows you to benefit from low rates
- Also comes with the option to switch to a fixed rate should interest rates look set to significantly rise
Cons of Flexible Mortgage
- A flexible mortgage contains a similar level of risk as a discount or tracker rate mortgage
- it’s up to you to make the switch to a fixed rate, which could be higher – the lender will not suggest when to make that switch
Offset Mortgages
Offset mortgages involve linking your mortgage account to a savings or current account. This allows you to offset the - hopefully - positive balance of your savings against your outstanding mortgage balance. Your interest is then calculated daily on the net balance between the 2 accounts.
Depending on the set up, your monthly payments can either remain the same while the term reduces, or you can keep the term the same so your monthly payments reduce. They’re highly useful to people with significant savings, as well as those who can afford overpayments. This is especially true for higher rate taxpayers. Not all lenders have the facilities to offer both offsetting methods so you should be clear about what you need before you apply.
Pros of Offset Mortgage
- The more money you can put into the offset savings account, the less you’ll pay in mortgage interest
- You can withdraw money out of your savings account with ease at any time, for any reason
Cons of Offset Mortgage
- There's generally a smaller pool of lenders that offer offset mortgages
- Due to the small pool of lenders, rates can sometimes be a little higher than standard products
Repayment Methods for Interest-Only Mortgages
When you choose an interest-only mortgage, you need to arrange a repayment method to pay back the capital at the end of the loan period. You don’t need to arrange a repayment method for a repayment mortgage, as you pay back a bit of capital each month alongside any interest charged.
There are numerous repayment methods for interest-only mortgages available, including a pension, ISA or equity in property.
You may have also heard of using endowments. These were a very popular repayment option some years ago, but they’re not really anymore. Nonetheless, we’ve given a bit of background about these as some people are still using the ones they chose way back when.
Pension
With a pension repayment vehicle, you make your monthly repayments of interest to the lender and contributions to a pension. This pension should provide a tax-free lump sum as well as a taxed regular income at retirement. You use most, if not all, of the tax-free lump sum to clear your mortgage loan at that date.
Pros of Pension as Repayment Vehicle
- Pension contributions qualify for tax relief of up to 40% - for a higher rate taxpayer
- This will boost the value of every pound you contribute to your pension
Cons of Pension as Repayment Vehicle
- Using your tax-free lump sum as a mortgage repayment vehicle may leave you with inadequate income in retirement
- The lump sum is only payable on retirement, so your loan term could be over 25 years - depending on how old you are and when you plan on retiring
- Poor performance could adversely affect the amount of the tax-free lump sum which could leave you with insufficient funds available to repay the loan at the end of the agreed term
ISA
When you use an ISA as a repayment vehicle, you make your monthly repayments of interest to the lender and you make contributions to an Individual Savings Account (ISA). ISA mortgages use stock market-based investments for tax-free growth.
There are 2 main types of ISA: "Cash" and "Stocks and Shares". There are different rules over contribution levels and a range of investments available in each.
Pros of ISA as Repayment Vehicle
- A well-performing ISA could potentially give you the means to pay off your mortgage early
Cons of ISA as Repayment Vehicle
- A poorly performing stock market could reduce the value of your investment
- This could leave you with a shortfall come maturity that you would have to somehow fund
Endowment
These are hardly used at all nowadays, but some people may have one from the past that they’re still using as part of their repayment strategy. With an endowment mortgage, you make your monthly repayments of interest to the lender alongside contributions to an insurance company to fund a savings plan. This savings plan aims to generate sufficient funds to pay off the capital at the end of your agreed mortgage term.
The savings plan can be “with profits”, unit-linked”, or a combination.
"With profits" policies pay 2 types of bonuses. An annual "reversionary" bonus that’s usually paid into the savings plan each year and, once awarded, is normally guaranteed - provided the policy is still active on the maturity date - and a "terminal" bonus that’s awarded on the policy maturity date. Its size will depend on the performance of the fund over the lifetime of the policy.
With "unit-linked policies", the value is driven by the underlying value of the investments when the policy reaches maturity.
If you pass away before the end of the term, the life insurance aspect of any endowment policy is used to clear the loan. The level of that cover should be reviewed regularly as people’s mortgage balances do not remain the same over a long period of time.
Pros of Endowment as Repayment Vehicle
- One benefit of an endowment repayment vehicle is that you keep the policy if you move house or change mortgage provider
- Endowments can include life and critical illness cover that can be cheaper than buying such cover separately
Cons of Endowment as Repayment Vehicle
- There’s no guarantee that your underlying investments will perform well
- You may wind up reviewing the monthly payments to your endowment policy and/or the actual repayment basis of your mortgage to ensure that the mortgage loan can still be repaid in full at the end of the agreed term
Equity in Property
Nowadays, lenders will consider the equity in other properties you may own as a means to cover some, or all of an interest-only mortgage. Some lenders will even consider the equity in your home as sufficient to simply allow “downsizing” as a repayment strategy. They have pretty strict rules surrounding this so you should talk to your lender or broker before suggesting equity in property as a repayment strategy.
Pros of Equity as Repayment Vehicle
- Using equity in property as a repayment vehicle offers the potential for downsizing as a way to repay the mortgage
- Homeowners can leverage the value of one or more properties
- It can make interest-only mortgage more accessible to hose who might otherwise struggle to find way to pay off the capital
Cons of Equity as Repayment Vehicle
- Property value can fluctuate, meaning there's the risk that you could be left without enough to repay the loan
- Lenders have strict criteria for accepting equity as a repayment strategy
- There's the risk of the forced sale of the property in order to repay the mortgage, especially if market conditions are unfavourable
- If the equity doesn't cover the full mortgage amount, the borrower may need additional funds to make up the difference
Even More Mortgages Explained
With so many different types of mortgages in the marketplace, you could be forgiven for not knowing all the types on offer. There really are a lot - but each one boils down to one of the above types.
It’s not made any easier by the fact there are different names for mortgages that have the same base elements – e.g. an interest-only fixed rate mortgage – and that some products are only available at certain rates to selected types of borrowers – e.g. first-time buyers, buy to let, or existing borrowers.
First-time buyer mortgage deals or buy-to-let mortgages, are still either repayment or interest-only, fixed rate or tracker rate, etc. Our advisers guide you through the terms and types, ultimately helping you figure out which deal is best. Call us on 0330 433 2927 or make an enquiry.
John Charcol is not authorised to offer investment advice. We recommend you seek professional advice about these topics if you believe they may affect or be of interest to you.
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