Understanding Mortgages

Introduction to Mortgages

If mortgages seem like a foreign language to you then your in the right place. In this article we aim to explain mortgages in plain English so that Joe Bloggs and CFO’s alike can get a  good understanding of what a mortgage is and its various forms.  Even astute financiers often find themselves overpaying for their mortgage lending just from not having a full view of the market or the time to look into their mortgage fully.

As with most things, the more options available the more difficult choosing becomes, and there are thousands of mortgage deals available, many with more than one name confusingly!

This amount of variation and choices does have its advantages to us the end users, there is a mortgage to suit everyone.  This is largely welcome by most borrowers  however, it doesn’t cater well for those who just wants to find the best mortgage ASAP.

Your mortgage is most likely the largest debt you will ever have and as such it is important to ensure your getting the best deal and are not overpaying for your mortgage borrowing.

It is a common mistake to take a mortgage up because it ‘does the job’ and you do not have time to shop around.  A mortgage broker can do all the research and advise you on your options, but before you speak with them its best to understand what a mortgage is in its different forms.

Step 1 – The Types of Products

Fixed rate mortgages

With fixed rate mortgages your interest rate is fixed for a predetermined period of time, usually around 2 years however longer fixed periods are available. Of late the government has been stimulating lenders to offer longer periods of fixed rates to attract more new buyers to the market however their uptake has been slow and the market shows signs that people prefer to be tied down for shorter rather than longer.

With fixed rate mortgages you will know your exact monthly commitment and can budget accordingly.

Tracker mortgages

Tracker mortgages ‘track’ the Bank of England base rate for an agreed length of time at an agreed %age above the BoE base rate. e.g. 0.07% above base rate for 2 years.

This type of mortgage is suited to individuals who are not budgeting as such and would like the potential of getting lower rates while being able to cover any increase in monthly costs.

Discount mortgages

Discount mortgages are similar to Tracker mortgages in that they indirectly tack the BoE’s base rate.

We say indirectly because by strict definition they track the lenders Standard Variable Rate less the ‘discount’ percentage. For example if the banks SVR is 6% and you have a 1.7% discount rate you will be paying 4.3%.

Warning: The lenders SVR does not necessarily track the BoE base rate. This may seem a little unfair but effectively the lender chooses how to adjust their SVR. If the bank of England raises their rates they may raise them in-line with the BoE (for example 25 basis point which is ¼ of a percent) they may exaggerate the increase (raise their SVR 30 basis points for every 25 of the BoE) or they may stay static (but we can’t see it happening!). This works the same for rate decreases.

Capped mortgages

Capped mortgages are similar to tracker mortgages with an additional level of security, the ‘cap’.

Capped mortgages will track the BoE base rate, however they will stop at a predefined upper level known as the ‘cap’.

This type of mortgage suits those who can handle the ups and downs of a tracker mortgage but are concerned about interest rates flying away.

So in summary capped mortgages offer you additional protection and a potential upside in the rates dropping but you will pay quite a premium at the start for having these securities.

Cashback Mortgages

Cashback mortgages are loans that provide you with a cash lump sum equal to a pre agreed %age sum.

of your mortgage borrowing, for example a 4% cashback on a £100,000 mortgage will return £4,000.

This mortgage is well suited to those who have a requirement for a cash lump sum or have a pre-existing financial commitment to meet such as a balloon payment.
Most cashback mortgages have early repayment charges attached and charge higher interest rates.

Offset mortgages

Offset mortgages are a relatively new product to the UK mortgage market. Offset mortgages work by ‘offsetting’ your mortgage payments against your savings or in even more modern mortgages, your current account.

What this means is your saving effectively earn the rate of interest your mortgage is charging. This offers some great advantages as you will not achieve a saving rate as good as your mortgage rate while it also has tax saving implications for certain individuals.

So if you have a £200,000 mortgage and £50,000 in saving, you will only pay interest on the remaining balance (£150,000).

Offset mortgages advantages start at holding about a 10% equivalency (holding 10% of the mortgage sum in savings). Offsetting mortgages can reduce the overall length of mortgages by up to 8 years 8 months!

Offset mortgages tend to have marginally higher interest rates

Flexible mortgages

Flexible mortgages is a blanket term for any mortgages that offer a greater level of flexibility than more traditional mortgage products. Common features of flexible mortgages are:

Flexible mortgages are perfect for those who have varying finances such as an irregular income or people who stand a good chance of settling the mortgage before its agreed term.

Flexible mortgages however command a premium and as such should only be used if the feature set offered is essential to your mortgage requirements. It is worth looking around, or asking your mortgage broker to, as many traditional mortgages offer flexible style benefits such as overpayments.

Summary:

Congratulations, you now know the basics of the 7 main types of mortgages available in today mortgage market and cut several thousand products down to 7!
Cheat sheet:

Now that you know what the main mortgages are, you can begin to make some informed choices. But you still need to know about the best way to pay back that money, and there’s allot to pay back, so doing it the right way will save you money.

Step 2 – How Should I Pay a Mortgage?

Interest only or repayment mortgage?

Interest-only mortgage

This means paying only the interest  on a month to month basis but not the capital. While this may sound like a dream come true, own a house and only pay the interest on the money I’ve borrowed Woo Hoo! This is not the case. Interest only mortgages, as with any mortgage should only be taken out if you intend to repay the capital.

As such when you take up a interest only mortgage most mortgage providers will require you to show you have an alternate investment in place that will cover the capital or make roads towards covering the capital owed.

Some mortgage lenders will not require this proof of investment but it does not change matters; only take an interest only mortgage if you have an alternate investment to pay off the capital or a good plan as to how you will.

The only exception to this rule is for first time buyers where some lenders will allow a period of interest only after which point the mortgage transfers to interest and repayment.

Repayment mortgage

As you may have guessed from the above, a repayment mortgage is a mortgage where you agree to both repay the interest on the loan and the loan itself. This means your monthly payments consist of both interest and capital. In the early period of your mortgage your monthly mortgage payment will largely consist of interest but as you near the end of the loan it will largely comprise of capital repayment.

Step 3 – How Often Interest Is Recalculated

Another factor to consider when looking at mortgages is whether to pay your mortgage lender daily, monthly or annual interest. The first thing to note is this only really affects repayment mortgages or an interest only mortgage that has allowed the borrower to make capital payments.

If you are making payments to your capital (a repayment mortgage) you will want the interest owed on the loan to be recalculated regularly as you are constantly reducing the overall loan amount and therefore the interest due.  If it is only update annually for example you are overpaying the amount of interest on the capital that has been settled that year.