What Type Of Mortgage Is Best For Me?

Saving for a deposit for a property is one thing; knowing what of mortgage is best for me is another. Here, we break down the jargon so that you know exactly which type of mortgage works best for you.

Trackers, variable rates, offset mortgages, discounted mortgages… the jargon used in the mortgage market can be confusing to say the least. Yet it’s jargon that you need to get your head around.

Buying a home is likely to be the biggest investment you’ll ever make. A mortgage (the name for a loan to buy a home) is likely to be the biggest debt you’ll ever take on. Use the wrong type of mortgage, and it could cost you thousands, affecting your long-term wealth.

In the worst-case scenario, the wrong type of mortgage could cost you your home.

Here’s what you need to know before seeking mortgage advice and/or applying for a mortgage.

Repayment Or Interest-Only?

The first decision before you apply for a mortgage will be whether to take a repayment mortgage or interest-only mortgage.

With a repayment mortgage, you repay the amount you have borrowed, plus any interest charged during the repayment period. At the end of your mortgage term, you will have repaid your mortgage, and the property will be yours.

If you opt for an interest-only mortgage, you don’t repay any of the capital that you borrow until the end of the mortgage term. Until you repay the outstanding amount, the lender retains a call on the property – if you can’t repay what you owe, the lender can repossess your home, no matter what it is worth.

With so much at stake, why would you want to take an interest-only mortgage? The reason is that your monthly payments will be lower.

For example, a 25-year repayment mortgage at an interest rate of 5% will cost £584.59 per month, while the same mortgage on interest-only terms will cost £416.67 per month. This doesn’t mean the interest-only mortgage will save you money in the long term:

🔹You’ll pay a total of £125,001 in interest on your interest-only mortgage to make a total repayment of £225,001.

🔹The repayment mortgage will cost a total of £175,377 – with interest totalling only £75,377.

It’s not hard to understand why most home buyers opt for a repayment mortgage, is it?

If you are considering an interest-only mortgage, you’ll need to be sure that you will have the money to repay the capital borrowed when it becomes due. This might be from an investment you have made, the tax-free cash lump sum from your SIPP, or other arrangement.

Whatever it is, my advice is to plan for repayment from day one.

Fixed Rate vs Variable Rate Mortgages

The next decision to make is whether to go for a fixed rate or variable rate mortgage.

With a variable rate mortgage, the interest you pay is regularly reviewed and revised by your mortgage provider. It can go up or down, and this will lead to your mortgage payments increasing or decreasing.

Great news when interest rates fall. Not so nice when they rise.

When interest rates are volatile, variable rate mortgages make budget planning much more challenging, because you never know how your mortgage payments may change from one month to the next.

With so much uncertainty surrounding variable rate mortgages, why wouldn’t you choose a fixed-rate mortgage? A fixed-rate mortgage removes the potential for your interest rate to rise. What’s not to like about this?

For a start, this certainty of payments comes at a price – fixed-rate mortgages are usually a little more expensive than prevailing variable rate mortgages, with the fixed rate a touch higher than the variable rate when it is set.

Also, if interest rates do fall you won’t feel the benefit, because your payments won’t follow suit.

Fixed-rate mortgages usually come with a term of two, three, or five years (and occasionally 10 years). If interest rates fall during this time, you could be locked in – and pay more interest than you might otherwise do.

If rates rise, make hay while the sun shines because, when your fixed rate does end, the rise in your repayments could come as a big shock.

There’s another downside to fixed-rate mortgages – if you wish to repay part or all your mortgage early, there is usually an early repayment penalty.

Different Types Of Variable Rate Mortgages

If you’re considering a variable rate mortgage, you’ll be faced with a choice of which type of variable rate mortgage to apply for.

Standard Variable Rate Mortgages

All mortgage providers set their own mortgage interest rate, called a standard variable rate (SVR).

Usually, these follow the Bank of England (BoE) Base Rate, but not always. A lender might reduce its SVR if it is trying to attract new mortgage business, increase it in anticipation of a rise in the base rate, or change the SVR for any reason they wish.

SVRs always appear to rise faster than they fall, and lenders can decide to increase them in line with a base rate rise, or by more or less than this. When base rates fall, they can choose to cut their SVRs by more or less than the corresponding fall in the base rate. They can also leave their SVR unchanged.

SVR mortgage interest rates are usually expensive when compared to fixed-rate mortgages. Typically, they will be a couple of percentage points above the BoE Base Rate. As I’m writing this article, the base rate is 5.25% and typical SVRs are in the region of 7% to 9%.

Though an SVR mortgage is expensive in comparison to fixed-rate and other variable rate mortgages, and you’re at the mercy of the lender when it comes to how your interest rate may change, it does have a couple of advantages.

First, arrangement fees are usually much lower. Second, you’ll be able to make early/overpayments on the mortgage without incurring fees or early repayment penalties.

When the term of a fixed-rate, tracker, or discount rate mortgage ends, you’ll usually revert to the SVR.

Tip Avoid what I call ‘SVR Shock’ by starting to review your mortgage options around six months before the fixed-rate term is due to end.

Tracker Mortgages

The interest rate on a tracker mortgage follows an economic indicator. Most tracker mortgages follow the BoE Base Rate, though this doesn’t mean the interest rate you pay will be equal to the BoE Base Rate.

Some tracker mortgages move in line below the base rate, while the majority track above it.

For example, a tracker mortgage might stipulate that the interest rate will be base rate -0.5%. In this case, if the base rate moves from, say, 4.5% to 5%, your mortgage interest rate will increase from 4% to 4.5%.

Similarly, a tracker that stipulates the mortgage interest rate will be base rate +0.5% will see the interest rate rise from 5% to 5.5%, if the base rate rises from 4.5% to 5%.

While tracker mortgages don’t remove all the uncertainty associated with flexible rate mortgages, you do know that the lender will never increase your mortgage’s interest rate by an unknown amount. Also, if rates do fall, you know that the interest you pay will also fall.

Discount Rate Mortgages

Many lenders also offer discount rate mortgages. The discount is usually the interest rate reduction from the lender’s SVR.

For example, a 2% discount mortgage might reduce the interest rate you pay from an SVR of 7.5% to 5.5%.

Sometimes, a lender will market a discount rate as the actual rate you pay – in which case, a 2% discount mortgage might mean that you pay an interest rate of 2% (this is rare, but it pays to read the fine print).

The discount will typically last for up to three years, though may be longer. During this period, the interest rate charged will depend upon the lender’s SVR, which can go up and down as they see fit.

Tip A 3% discount mortgage might not be cheaper than a 2% discount mortgage; it all depends upon the lender’s SVR, so make sure you consider the underlying interest rate that you will pay.

Capped-Rate Mortgages

Capped-rate mortgages combine some of the advantages of fixed-rate mortgages with the flexibility of flexible-rate mortgages.

It’s a simple idea – the mortgage provider places a cap on the interest rate it will charge you. If it increases its SVR above this, you won’t pay the higher rate.

This doesn’t mean your interest rate won’t rise, merely that you know the full extent to which it could increase. If interest rates fall, your interest rate could fall, too.

This arrangement gives you increased peace of mind. From the outset, you’ll know that you can afford the absolute maximum interest rate that could be applied to your mortgage, regardless of where interest rates head to.

However, capped rate mortgages are usually accompanied by higher fees and up-front charges, and you could incur early repayment charges if you wish to overpay on your mortgage. If the SVR never rises above the cap, you could have paid hefty charges for no financial reward.

Offset Mortgages

If you have a reasonable amount in a savings account, you could use this to reduce the amount of interest you pay on your mortgage. This arrangement is called an offset mortgage. Here’s how it works:

• You have a mortgage for £200,000.
• You have a deposit account with a balance of £40,000, held with the lender.
• The lender reduces your mortgage by your savings balance.
• Mortgage interest is charged on £160,000.
• You don’t earn any interest on your savings account.
• You save 20% on the interest you would have paid.

This could be a great option if you want to keep your savings intact and accessible (though any withdrawals will have a negative effect on the advantages of an offset mortgage). Meanwhile, you’ll probably save more in mortgage interest than you would earn on your savings.

Tip Before applying for an offset mortgage, do the maths. The interest rate may be higher than for other types of mortgages, and if you can afford to use your savings to have a smaller mortgage, this might be preferable.

First-Time Buyer Mortgages

These are mortgages that have been especially designed for people buying their first home. Often with lower application fees, this type of mortgage usually welcomes homebuyers with a low deposit.

They also often include discounted interest rates for six months to two or three years. This will help you afford the mortgage repayments on your first home, but you’ll need to be careful of the small print: the interest discounted may be added to your outstanding mortgage (so it’s more like a deferral than a discount).

Guarantor Mortgages

If you’re not able to get a mortgage – for example, if you are short of the deposit you need – you might consider using the ‘Bank of Mum and Dad’, asking them to loan you the money for your deposit.

There are other ways that friends or family can help you to secure a mortgage, though. One of these is to apply for a guarantor mortgage.

Instead of lending you the money for your deposit, your parents (or someone else) could act as guarantor, promising to make your mortgage payments for you if you default. You may be able to secure a 100% loan this way, or borrow more money than you could without a guarantor.

Sounds great, doesn’t it? It can be, but a guarantor mortgage also carries a high degree of risk – and, in my experience, this risk is much more than financial.

First, your guarantor will be credit checked, which will show on their credit record. If they later wish to borrow money, your mortgage – and their liability on it – will count against them.

Most importantly is this – what happens should you default on your mortgage? Say, for example, you lose your job, or illness means you can no longer work. The guarantor will be legally bound to make your mortgage payments for you.

This could put them under financial stress, and lead to arguments and worse. I’ve seen families torn apart because of this type of financial arrangement.

Key Questions To Ask Yourself When Mortgage Hunting

Okay, now you have a solid foundation – you understand the diverse types of mortgages available. How do you decide which is best for you?

When I wanted to buy my first home, I spoke with a great mortgage broker, and he asked me a few questions that I have never forgotten. Answer these and you’ll know what type of mortgage you need.

1. How Important Is Peace Of Mind To You?

Financially, peace of mind comes from knowing how much you’re paying out each month – and that you can afford these payments.

If you’re the type of person who benefits from having a more rigid budget, knowing what is leaving your account each month, or one who could not contemplate a rise in mortgage rates, then a fixed-rate mortgage is likely to be best.

If you’re less risk averse and happy to take a chance on rates going down (and benefiting from lower mortgage payments), then a variable rate mortgage may be right for you.

The middle road is a capped-rate mortgage – you’re the type of person who’s willing to take some risk, while retaining the opportunity to fully benefit from a fall in interest rates.

2. Will You Want To Make Early Repayments On Your Mortgage?

Overpaying your mortgage each month or making lump sum payments in addition to your regular payments (for example, if you receive bonuses from your work) can drastically reduce how long it takes to become mortgage free and the amount of interest you pay.

If this is a strategy you plan to follow, then you’ll need to be careful to apply for a mortgage that allows you to do this without incurring hefty penalties for early repayment. This could rule out many fixed-rate deals.

3. How Much Deposit Can You Afford?

Generally speaking, the higher your downpayment the more you can afford to borrow. But the size of your deposit has a much bigger effect than this.

When a mortgage provider assesses your application, one of the most crucial factors they consider is Loan to Value (LTV).

The bigger your deposit in relation to the value of the property you wish to buy, the lower the LTV – and the lower the LTV, the lower the mortgage interest rate is likely to be, making your mortgage cheaper.

With a lower LTV requirement, you are also likely to have a greater mortgage choice – because lenders like safer bets, and the equity in your home (the property value less the amount outstanding on your mortgage) is their cushion should you default and they repossess your property.

4. When Do You Expect To Retire/Stop Work?

Now, this might seem a curious question, but it’s a key factor to consider nonetheless. Assuming you wish to repay your mortgage by the time you do retire, of course.

What this question is really asking is, how long do you want to be paying a mortgage for? The most common term is 25 years, though 30-year mortgages are becoming more popular, and even longer-dated mortgage terms are available.

Remember, the longer the term, the more you’ll pay in interest over the period of the mortgage. Also, wouldn’t it be nice to have a few years before you retire when you don’t have to worry about making monthly mortgage repayments?

5. Do You Plan To Buy On Your Own Or With Someone Else?

Joint mortgages – a mortgage in which two or more people join forces to borrow the money to buy a property – are now the most popular form of mortgage in the UK, with around 6 in 10 mortgages provided on a joint basis.

You may be able to borrow more (as more than one salary is counted), and with joint savings toward a deposit your LTV could be lower. Often, this means you can get on the property ladder earlier.

On the other hand, all borrowers are jointly liable for the mortgage – so if one person defaults on their part of the payments, then the other must make up the shortfall. Another consideration is, what if you want to sell, but your co-owners don’t?

6. Do You Have An Emergency Fund?

Especially if this is your first home, it’s difficult to save a deposit. (If you are saving for your first home, I recommend you open a Lifetime ISA (LISA) and benefit from a 25% government bonus on your savings.)

Because of this (and, let’s be honest, the fear of house prices continuing to rise beyond reach), it’s tempting to buy as soon as you have the deposit saved. The trouble is you then have no savings to fall back on in an emergency.

Before committing all your savings to a deposit, think about how you would survive financially if the worst should happen – for example, if you lose your job.

How would you pay your regular bills and put food on the table? How would you keep up with the monthly mortgage payments? If you don’t, how will you cope with having your home repossessed?

My advice is to make sure you have an adequate emergency fund stashed away (at least three months’ expenditure). If you’re not getting a great interest rate on your savings, and want to make them work toward repaying your mortgage, you could consider an offset mortgage.

7. What Would It Take To Make Your House Your Home?

Whether you are buying your first home or moving to a new home, when you exchange contracts and first move in, it’s an empty shell. You’ll need kitchen appliances, carpeting, furniture, and you might want to redecorate.

Whether you plan to buy new or used, all this costs money.

It can take months (or even years) to turn your ideal house into a dream home – you don’t have to do it all as soon as you move in. How are you going to fund this transformation? From your savings?

Another option is to budget to add to your house each month – and a discount mortgage could help you do this. The lower interest you pay during the discount period could be the boost you need to make your dream a reality.

Know What Type Of Mortgage You Need Before Seeking Advice

A mortgage broker can give you personalised advice and help you select the best mortgage for you based on your unique financial circumstances. However, the advice you receive can be overwhelming – there’s a lot of technical jargon to cut through.

By knowing your options and the pros and cons of several types of mortgages, and understanding your preferences regarding fixed vs. variable rates, repayment vs. interest-only options, and the importance of overpayments and deposit size, you’ll have a better conversation with mortgage brokers and mortgage providers.

This will ensure that you choose the right mortgage.