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Types of Mortgage

Introduction

With Bank of England figures revealing that more than £30 billion was lent for new mortgages and remortgaging during September 2006, home loans are big business.

Against a background of changing lifestyles and work patterns, not to mention fierce competition among lenders, the mortgage market has become increasingly complex. Finding the right loan can be a minefield.

Mortgages - demystified

The bad news is that there are apparently so many different kinds of mortgage. The good news is that there are only two basic types, repayment and interest-only, all mortgages being variations on one or other theme.

Repayment

With the repayment mortgage, each monthly payment includes part of the original sum borrowed plus the interest accrued. Though the payments may seem comparatively high, you are assured of owning your property outright at the end of the mortgage term.

Traditionally, repayment mortgages imposed penalties for any deviation from the agreed payment schedule. However, some lenders now offer customers the option of paying more when they can afford to, thus saving on interest payments in the long run, or paying less if they have short-term cash-flow problems.

Interest-only

With the interest-only mortgage, your monthly payment is equivalent only to the interest accrued. At the end of the mortgage term, you still owe the entire amount of capital borrowed.

Because monthly payments are lower, this type of mortgage tempts many. However, it’s essential to make proper provision for paying off your debt at the end of the term, through an insurance plan, ISA or other investment, and not just hope for a windfall – or a miracle – at the crucial time.

The well-publicised crisis over endowment mortgages (see Choosing a Mortgage), which has left millions of investors facing significant shortfalls in the amount of money available to pay off their mortgages, illustrates the potential risks of interest-only mortgages. A repayment option may be safer.

Paying the interest

Interest payment arrangements can be variable, fixed or capped.

Shop around for the best deal, ensuring you are comparing like with like by obtaining quotes for the same capital sum borrowed over the same term. Be sure to scrutinise the Annual Percentage Rate (APR), which includes all the costs of the mortgage (application fee, valuation and so on), rather than the headline interest rate.

Variable

Mortgage lenders set their interest rates above the Bank of England base rate, usually by 1–2 per cent. With a variable rate loan, the interest payable on your mortgage will vary with the base rate. If interest rates fall, you pay less. If they rise, you pay more.

Most mortgage providers offer potential customers a discount on their variable rate for a limited initial period. Your payments will still fluctuate with changes in the base rate, but they will be less than they would have been with the standard variable rate mortgage.

Because new customers are generally offered preferential rates, it’s worth reviewing your mortgage every few years to ensure you get the best deal.

Fixed

With a fixed rate loan, the interest rate is fixed for an agreed period, usually between a year and five years. After this, it generally reverts to the lender’s variable rate.

The benefit of this type of arrangement is that it enables you to budget with confidence, at least in the early stages, and if interest rates rise, you should be quids in. Should interest rates fall, however, you may be paying more than you would have done had you chosen a variable rate loan.

Capped

With a capped rate, an upper limit is put on the amount of interest you will pay over an agreed period, but there is no lower limit, so you benefit if interest rates fall.

While this is useful in helping you to budget, you will usually find yourself paying a higher rate of interest than you would with a fixed rate or discounted rate mortgage.

Choosing a mortgage

Finding your way through the home loan labyrinth can be tough. We recommend consulting an Independent Financial Adviser (IFA), who can help you make the most appropriate choice, bearing in mind all your financial and other circumstances.

In addition to the various specialist loans available, such as buy to let mortgages and expatriate mortgages, here are some of the types you may come across:

The offset mortgage

Offset mortgages are relatively new. They are so called because money in current and/or deposit accounts is set against the balance of your mortgage. Interest is only charged on the outstanding amount, so your interest payments are lower.

There are two kinds of offset mortgage, one of which (the current account mortgage) combines your bank account with your mortgage account, and the other of which allows you to keep your funds in separate accounts (for example, current, savings and mortgage). With both types, all balances are taken into account when interest is calculated.

Most borrowers make monthly repayments. This guarantees that the mortgage will be repaid eventually, regardless of offset.

Offset mortgages have several advantages, among them flexibility (for example, you are unlikely to face penalties for redeeming your mortgage early) and reduction of your tax liability.

On the downside, interest rates are generally higher than those on traditional mortgages, and offset mortgages may only be worthwhile for those who keep a significant amount of money in their current account and/or have reasonable levels of savings.

The cashback mortgage

As its name implies, this offers you cash, in addition to the sum you are borrowing. With all the expenses of moving house, such deals can seem attractive, but they are often expensive in the long term and are used by some lenders to tie you to them, through various conditions.

If you need cash, there may be more cost-effective means of obtaining it, so investigate all avenues.


The endowment mortgage

Endowment mortgages were all the rage during the 1980s and early 1990s, but have now fallen from favour with a resounding crash.

With this type of mortgage, the homebuyer made monthly payments into an endowment plan, which, when it matured, was forecast to provide enough cash to pay off the capital sum borrowed. Meanwhile, he paid interest on the loan each month.

Those who took out such plans in earlier years, when the Stock Market was booming, did very well; it was not uncommon for them to be left with a sizeable cash surplus after the mortgage was paid. However, times have changed, and, in recent years, many people have had their fingers badly burned by plans that have failed to provide the amounts predicted.

The ISA mortgage

This works on the same principle as the endowment mortgage; you invest in a product that is predicted to grow sufficiently to repay the capital sum borrowed at the end of the mortgage term. The big drawback – uncertainty as to the performance of your investment – is also the same.

The 100 per cent mortgage

Whereas most lenders offer a loan-to-value ratio of 75–95 per cent maximum, some are now offering 100 per cent mortgages; a few go as high as 125 per cent. However, as well as being expensive (you will pay a higher interest rate), this level of borrowing is risky. If interest rates rise or your circumstances change, you may not be able to meet the mortgage payments. Should this happen and you have to sell your property, you may not be able to raise enough from the sale to repay the loan. And if property prices fall, you risk being plunged into negative equity, where the value of your home is less than the amount of your mortgage.

Last Word

Although it’s been said many times before, it bears repeating: you risk losing your home if you don’t keep up your mortgage payments.

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