You’re excited to buy a property and ready to apply for a mortgage but with so many types to choose from, it’s hard to know where to start. We’ll detail the main types for you here to help you decide.
What is a mortgage and do you need one?
To purchase a property, it’s more likely than not that you’ll need a mortgage to be able to afford it unless you are lucky enough to have the full funds available. As properties are so expensive, having the full funds at your disposal is doubtful so you’ll need help in the form of a mortgage deal.
A mortgage is, therefore, a loan from a lender that allows you to purchase a property. You repay this loan as well as interest over an agreed mortgage term, such as 25 years. The monthly amount you pay for your mortgage depends on the amount you borrow, the length of the mortgage term, the interest rate you have agreed to and whether you have chosen a repayment or interest-only mortgage.
As you won’t own the property outright until the mortgage has been repaid, the lender considers the property to be collateral and has the right to repossess it if you fail to make your mortgage payments. To ensure this doesn’t happen, it’s essential you choose the right type of mortgage and we’ll explain the different options available to you here.
The differences between repayment and interest-only mortgages
Repayment mortgage (capital and interest mortgage)
With a repayment mortgage, you make monthly payments to pay off the loan amount (the capital) plus interest. This is a popular choice because it means you repay your loan in full over the mortgage term, such as 25 years, and own the property outright at that point.
With an interest-only mortgage, you do just that — you only pay the monthly interest and don’t pay off any of the loan for the capital. The capital loan has to be repaid in full at the end of the mortgage term and you’ll need to provide your lender with proof that you can do this, such as investments or a savings plan, when making your mortgage application.
This type of mortgage can be appealing because your monthly payments are a lot lower without the need to pay off any of the capital. However, you do have to remember that the entire loan must be settled at the end of the mortgage term.
Fixed rate versus variable rate mortgages
Fixed rate mortgages
This type of mortgage allows you to pay a fixed interest rate for a set period, such as 2 years or 5 years, at the start of your mortgage. This is good for budgeting because you know exactly what you’re paying each month and it also gives you peace of mind that your payments won’t suddenly increase if the Bank of England increases the interest rate.
What you need to be aware of, however, if that after this initial term, the interest rate will revert to your lender’s standard variable rate (SVR). This is usually higher than the interest rate you’ve just been paying. It’s a good idea to look for an alternative deal a few months before the fixed rate period is due to end to avoid having to pay the higher standard variable rate.
Fixed rate mortgages tend to have higher rates of interest than variable rate mortgages and you don’t benefit if the interest rates drop. You’re also likely to face early repayment charges if you choose to switch to a new mortgage deal.
Variable rate mortgages
A variable rate mortgage means that the amount you pay for interest each month increases or decreases according to different factors.
Choosing a mortgage with the lender’s standard variable rate is not recommended because lenders set and adjust this rate themselves and it is usually high compared with other rates. However, if you choose to remortgage or find a new home, you won’t have to pay early repayment charges.
Other variable rate mortgages include discounted rate, tracker and capped rate mortgages.
Discounted rate mortgages
This type of mortgage gives you a discount on the standard variable rate set by the lender. This applies for a specific period, which is generally between 2 and 5 years. At the end of this period, the rate switches to the lender’s standard variable rate, which is much higher. The discounted rate can make your mortgage payments much cheaper but, as the rate is linked to the SVR, the payments can still increase if the lender increases the SVR rate.
The monthly rate you pay depends on the interest rate that’s being tracked – this is usually the base rate set by the Bank of England – and a fixed percentage is also added to this rate. This means your payments increase or decrease as the base rate changes. You can choose whether you want the tracker rate to apply for an introductory period or the entire mortgage term.
Capped rate mortgages
While this rate increases and decreases in the same way as other variable rate mortgages, a cap is set so that the rate cannot exceed that amount. This lets you benefit from lower payments when the interest rate drops but also gives you peace of mind when the rate increases as you know the maximum amount you will have to pay. As a capped rate offers you more security, the interest rate is usually higher than a tracker or discounted rate mortgage.
An offset mortgage can have a fixed or variable interest rate depending on the deal you choose. This type of mortgage reduces the amount of interest you have to pay on your mortgage by using your savings. You won’t earn interest on your savings but the lender will take your savings into account when calculating the amount to charge interest on. For example, if you have a mortgage of £150,000 and savings of £20,000, you only have to pay interest on £130,000.
This type of mortgage is flexible because you can increase or decrease your mortgage payments as you need to. You also don’t pay any tax on your savings because you’re not earning interest on them. But be aware that you usually have to pay a higher rate of interest to benefit from an offset mortgage.
Other types of mortgage
These are the main types of mortgages but you’ll find many mortgage deals available to suit individual circumstances. A first-time buyer’s mortgage, for example, usually caters for a lower deposit and offers lower fees. A shared ownership mortgage only relates to your share of the property.
If you want a bigger mortgage than you can afford on your own, you can ask a family member to agree to a guarantor mortgage, in which he/she becomes liable for your mortgage payments if you are unable to pay them. To purchase a property with the intent of renting it out, you need a buy-to-let mortgage. As well as your personal finances, the lender will take into account the amount of rental income you are expecting.