How To Choose The Right Mortgage For Your Needs

Wednesday 13 December, 2023

How To Choose The Right Mortgage For Your Needs

Most home buyers in the UK take out a mortgage. There are different types of mortgages available to suit different sorts of buyers, potentially complicating your decision to take out a home.

This guide will take you through the options, including capital repayment and interest-only mortgages – as well as what to consider when choosing between a fixed-rate or a variable-rate deal, and leave you well-placed to make a more informed decision.

Please note: This guide is focused on the UK market. 

Capital repayment and interest-only mortgages

With a capital repayment mortgage, your monthly repayments are made up of both the amount of money you’ve borrowed (the “capital”) and the interest on that loan. At the end of your mortgage, you’ll have paid off all the debt and the interest owed, meaning you’ll own the entire property outright.

In the early years of your mortgage, when the amount of debt you owe is higher, most of your monthly repayments go towards paying off the interest. Gradually, as you reduce what you owe, the majority of your repayments go towards paying off the debt itself.

With an interest-only mortgage, your monthly repayments only include the interest on your loan and don’t reduce the actual amount you’ve borrowed. So at the end of your mortgage, you’ll still owe the amount you borrowed and won’t own the property outright…

Unless that is, you’ve been building up a cash pile to pay off your debt at the end of the mortgage term. For example, making regular investments into a tax-free Individual Savings Account (ISA) or using the tax-free lump sum from a pension could give you enough cash to clear your outstanding debt and own your home completely.

Interest-only mortgages have lower monthly payments, which makes them more affordable. But they’re usually only on offer to buyers who have a solid plan to repay the capital and are particularly popular with “buy-to-let” investors.

Buy-to-let investors tend to prefer interest-only mortgages as lower monthly payments mean higher profits. That said, the interest rates on buy-to-let mortgages are usually higher than those on properties owners intend to live in because lenders consider them riskier bets. Say you have two mortgages, one on your home and another on a rental property: if you’re struggling to make both payments, you’ll probably choose to pay the mortgage on your home rather than on the rental property.

An offset mortgage is a mortgage with a savings or current account linked to it. The attached account can reduce the amount of interest you’re charged as the lender subtracts the savings in your linked account from the outstanding mortgage balance before calculating the interest.

When there’s enough money in your offset account to reduce your interest payments, you can decide whether to pocket the savings or keep paying as usual. If you choose the latter, you’re essentially overpaying and could end up paying off your mortgage sooner.

As fewer lenders offer offset mortgages, they often have slightly higher rates than comparable products. Offset mortgages are typically most useful if you have significant cash savings to hand.

Fixed and variable-rate mortgages

Fixed-rate mortgages

With a fixed mortgage, you’ll be charged a set interest rate for a specific period of time, regardless of what happens to interest rates elsewhere. During that time, your repayments stay the same each month and you can budget accordingly. Rates are usually fixed for either two, three, five, or 10 years.

The main drawback is that if interest rates fall, you won’t see your monthly payments drop. Additionally, there will likely be expensive fees if you want to switch to a cheaper mortgage or pay off your debts early.

Variable rate mortgages

Variable rate mortgages mean that your interest rate moves up and down, normally in line with interest rates set by the Bank of England. At times of high inflation, interest rates typically increase, which makes your mortgage repayments more expensive each month. At times of economic slowdowns or low inflation, interest rates are often cut.

There are three types of variable rate mortgages: tracker rate, standard variable rate, and discounted variable rate.

The interest rate of a tracker rate mortgage typically follows the Bank of England’s base rate. The rate you pay is usually slightly higher – by around 0.5% – than the base rate and is generally set for between one and five years, but can last longer.

An advantage of a tracker rate is that if the base rate falls, your mortgage rate will also fall. But the opposite is true: if interest rates increase, you’re locked into paying a higher rate.

When your fixed-rate mortgage ends (if you have one), you’ll usually be transferred to a standard variable-rate mortgage (SVR). Every lender has a standard variable rate which they can change when they like, but it normally moves in line with changes in the Bank of England’s base rate and is often set two to five percentage points higher than it.

If the base rate drops, it’s likely, but not guaranteed, that the SVR will drop too. One advantage of SVRs is there are no early repayment charges in most cases, should you be able and choose to. However, like other variable rates, you will pay higher monthly payments if the base rate moves up.

Sometimes lenders offer a lower rate than their SVR for a set period of time. These are discount-rate mortgages and are always worth comparing to the prevailing SVR and to other interest rates on offer elsewhere.

Like other variable rates, a discount rate mortgage will likely fall when the Bank of England’s base rate is lowered and vice-versa if the base rate is increased. Remember, there is no guarantee that a lender will reduce its SVR if the Bank of England cuts its base rate.

What factors are important when choosing a fixed or variable rate?

A mortgage payment is usually a homeowner’s largest monthly expense. Your primary consideration then, should be being able to continue to make your monthly payments. If increased interest rates would make it significantly harder, then locking into a fixed rate can give you peace of mind.

If, on the other hand, you’ve got a lot of money in cash and short-term investments and you think interest rates might soon fall, then you could go for a variable-rate mortgage option. If you’re wrong, you’ll have enough cash on hand to make your monthly payments. And if you’re right, your payments will fall. Variable-rate mortgages are also worth considering if you think you may sell the property shortly after taking out the mortgage, as they’re less likely to attract early repayment fees.

Keep an eye out for mortgages that come with special features, like allowing overpayments, offering payment holidays, and borrowing back cash if you previously overpaid.

The Bank of England’s base rate has moved sharply higher from 0.1% in December 2021 to 5.25% in October 2023, so mortgages have also become more expensive. However, investors expect interest rates to fall over the next five to ten years, and as a result, five and 10-year fixed-rate mortgages are currently on offer with lower interest rates than two and three-year fixed-rate deals (typically, shorter-term mortgages have lower rates than longer-term mortgages). It always pays to check the whole mortgage market carefully before choosing the best product for you.

In this guide, you’ve learned:

• With a capital repayment mortgage, you pay off all the debt and the interest during your mortgage term but with an interest-only mortgage, you only pay off the interest on your loan and don’t reduce the amount you’ve borrowed.
• A fixed-rate mortgage has an interest rate that remains unchanged for a set period of time, protecting you from higher monthly payments if interest rates increase – but you could lose out if interest rates fall.
• With variable-rate mortgages, monthly payments increase or decrease if the central bank base interest rate rises or falls.

In Summary…

Call our mortgage broking teams in St Albans and Lichfield if you want personalised mortgage and protection advice.

As a mortgage is secured against your home or property, it could be repossessed if you do not keep up the mortgage repayments.  The information contained in within this article is for guidance only and does not constitute advice which should be sought before taking any action or inaction. The Financial Conduct Authority do not regulate some forms of buy to let mortgages.

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