Mortgage types explained
All mortgage types work in the same way: you borrow money to buy a property over a set term, and pay interest on what you owe.
How much you pay back each month is determined not only by how much you have borrowed, and the rate of interest you are paying, but also how long your mortgage term is, and whether you have opted for an interest-only or repayment mortgage.
Repayment versus interest-only mortgages
Most mortgages are arranged on a repayment basis, also known as a Capital and Interest mortgage. This means that every month you repay a portion of the capital you have borrowed, as well as a part of the interest you owe.
At the end of your mortgage term, assuming that you have completed all the payments, you will have repaid the original amount you borrowed, plus interest, and you will own your home outright. If you prefer, you can opt for a shorter or longer mortgage term depending on how much you can afford to pay each month.
Some mortgages, however, are arranged on an interest-only basis. This means that you will repay the interest you owe each month, but not any of the capital that you have borrowed. Therefore, you only pay off the original amount you borrowed at the end of the mortgage term.
An interest-only deal is advantageous as monthly payments will be much lower than with a repayment mortgage, but the downside is that you must be certain you will have saved up enough by the end of the mortgage term to repay the amount you borrowed.
In order to be eligible for an interest-only deal, you will have to prove to the lender that you have got a savings plan in place to facilitate this.
What are the different types of mortgage?
There are two main types of mortgage:
- Fixed rate mortgages
- Variable rate mortgages, which include:
- Tracker mortgages
- Discounted rate mortgages
- Capped rate mortgages
Fixed rate mortgages
As the name indicates, a fixed rate mortgage involves paying a fixed rate of interest for a set term, normally ranging from two to ten years, or sometimes even longer. This can offer you valuable peace of mind, particularly as your monthly mortgage payments will be the same every month, regardless of whether or not interest rates increase on the wider market.
However, the downside is that if interest rates plummet, you will be locked into your fixed rate deal.
If you decide you want to pay off your mortgage and switch to a new deal before your fixed rate deal ends there will usually be Early Repayment Charges (ERC’s) to pay.
Once the fixed period has ended, you will normally move onto your lender’s Standard Variable Rate (SVR), which is likely to be more expensive. If your fixed rate deal is coming to an end in the next few months, it is advisable to start exploring your options now.
Many lenders allow you to secure a new deal several months in advance, allowing you to switch across as soon as your current rate ends, and avoid moving to a higher SVR.
Variable rate mortgages
If you have a variable rate mortgage it means your monthly payments can fluctuate over time.
Most lenders will have a Standard Variable Rate (SVR), which is the rate charged when any fixed, discounted or other type of mortgage deal comes to an end. There are usually no Early Repayment Charges (ERCs) if you wish to switch to avoid your lender’s SVR.
There are several other types of variable rate mortgage available too. These include:
- Tracker mortgages
- Discounted rate mortgages
- Capped rate mortgages
Tracker mortgages track a nominated interest rate (usually the Bank of England base rate), plus a set percentage, for a certain period of time. When the base rate goes up, your mortgage rate will rise by the same amount, and if the base rate drops, your rate will simultaneously go down. Some lenders set a minimum rate below which your interest rate will never drop (which is known as a collar rate) but there is usually no limit to how high it can go.
Discount rate mortgages
Discounted mortgages offer you a reduction from the lender’s Standard Variable Rate (SVR) for a certain period of time, usually two to five years. Mortgages with discounted rates can be some of the cheapest deals but, as they are intertwined with SVR, your rate will go up and down when the SVR changes.
Capped rate mortgages
Like other variable rate mortgages, capped rates can go up or down over time, but there is a limit above which your interest cannot rise, known as the cap. This can reassure you that your repayments will never exceed a certain level, but that you still reap the benefit when rates go down.
Capped rate mortgages offer additional security as the deal means interest rates tend to be slightly higher than the best discounted or tracker rates. There does tend to be an Early Repayment Charge (ERC) if you pay off the mortgage in full and remortgage to another deal.
Other kinds of mortgage
An offset mortgage allows you to offset your savings against your mortgage, so that instead of gaining interest on your savings, you are charged less interest on your mortgage debt. For example, if you have a mortgage of £150,000 and savings of £15,000, your mortgage interest is calculated on £135,000 for that month.
Borrowers can normally choose to either reduce their monthly mortgage repayments as a result of the reduced interest charge, or keep their monthly payments as they are in order to reduce the overall term of their mortgage by paying it off sooner.
As you do not earn interest on your savings, there is no tax to pay on them, and you can extract your money at any time. Offset mortgages can either have fixed or variable rates, depending on which deal you want.
Buy to Let mortgages
Buy to Let mortgages are for people who wish to purchase a property and rent it out rather than reside in it themselves.
The amount you can borrow for a Buy to Let mortgage is based on the amount of rent you expect to receive, but lenders will take your income and personal circumstances into consideration too. They must also apply a ‘stress test’ so that they can ensure you would be able to afford higher mortgage rates in the future. First time buyers will find it a greater challenge to secure a Buy to Let mortgage.
What else do you need to know?
The size of your deposit or the level of equity you have in your property will dictate the range of mortgage deals available to you. Those with larger deposits are usually offered the best rates by lenders as they are generally considered lower risk.
If you are a first-time buyer and find it impossible to build a big deposit, do not despair, as several lenders offer 95% mortgages, whereby they will lend you up to 95% of the value of the property you are buying.
When you come to select a mortgage, do not focus on the headline rate solely. It is equally as important to consider the other costs, such as the arrangement fee, and to look at any incentives that the mortgage may entitle you to, such as cashback, help with a valuation or legal costs.