Which type of mortgage is right for me? This is one of the most common questions sent in by our readers. This guide seeks to answer those questions. Below, you will find an explanation of the different types of commonly available mortgages in use today.
Good News and Bad: Fewer Mortgage Types Available
Homebuyers today have fewer mortgage options than people who bought during the housing boom. In those days there were "exotic" mortgages, when lenders were tailoring their mortgage products to meet the needs of often-unqualified borrowers and over valued properties.
And then came the housing crash. Many of those bad loan mortgages went belly up, and so did the lenders who made them. You know the rest of the story -- foreclosure crisis, bank failures, bailouts, recession, etc.
So now here we are in 2013. Most of those risky mortgage types are no longer available. New regulations have been placed on the lending industry and we have gotten back to the basics, which is both good news and bad news for homebuyers:
•It's good news, because you won't be nearly as confused when looking for a mortgage. There were many different and confusing options to choose from before. But things are much simpler now.
•It's bad news because you may find it harder to qualify for a mortgage. If you have a lot of debt, or a bad credit score, you might not be able to qualify at all. Most of the "backdoor" or high loans to valuation mortgage options are gone.
When choosing a type of mortgage today, it will basically come down to two main choices. Do you want a fixed or adjustable-rate mortgage? Once you answer these two questions, the rest of the process is pretty straightforward.
In a hugely competitive market, building societies and banks are continually updating and extending their range of mortgages. The list is already extensive enough to baffle all but the most determined.
The most important points are how you pay back the capital you borrow and how you pay the interest on it.
Paying back the capital
You can either pay a little at a time as you go (repayment mortgage) or pay it all off at the end (Interest only or endowment mortgages).
• Repayment mortgages - Each monthly payment pays off a little of the underlying debt, as well as interest on the loan. At the end of the term the mortgage is cleared.
This is widely considered to be the most easy to understand and least risky mortgage type. But remember if you do not keep up with repayments the lender can repossess the property.
• Interest only mortgages - With this type of mortgage, you pay-off the interest on the loan but not the capital. At the end of the mortgage term you are expected to repay the capital, how you fund this is your business. The borrower often takes out an alternative method of paying off the mortgage capital such as an ISA, pension plan or endowment policy.
Interest only mortgages had grown in popularity in recent years amongst buy-to-let investors and first-time buyers in particular because, put simply, they are cheaper than a repayment mortgage.
However, today some experts are concerned that many people taking out an interest only mortgage are not giving enough thought as to how they will repay the capital.
If the investment performs badly, you could face a shortfall on your loan at the end of the repayment period. In the 1980s endowments were very popular and heavily marketed by lenders.
However, many people were not told of the investment risk. This was mis-selling and lenders faced huge claims for compensation.
As a result, interest mortgages have declined sharply in popularity.
Paying the interest
You have to pay interest on any debt, and mortgages are no different. They differ only in the range of options offered.
This means you pay the going rate on your mortgage. The mortgage rate changes every time interest rates change or, as in some cases, the overall effect of any interest rate changes is calculated once a year and payments are altered accordingly. Whatever kind of mortgage you start with, it is likely to change to variable rates at some point.
Is it right for me?
Yes – If you can afford to pay more when mortgage interest rates go up and want to take advantage of lower payments if rates fall.
No – If during the early years you would be unable to cope if repayments increased because of rising interest rates.
The interest rate is fixed for the period agreed - often two to five years. These are ideal for budgeting or if you think rates might increase. You do not benefit if rates fall, and will face penalties if you try to repay your mortgage early.
Very low rates may tempt you, but they can be used to trap you into paying over the odds at a future date. Check how long you will have to stay with the mortgage lender before you can change without penalty.
Is it right for me?
Yes – If you need to budget with certainty for the next few years, or if you think mortgage interest rates will rise, or both.
No – Probably not if you think mortgage interest rates will fall.
Capped & Collar rates
Such deals can be a good for budgeting. With a capped rate mortgage the interest rate can go up or down in line with movements in the lender’s standard variable rate, but cannot go above a set upper limit, known as the ‘cap’ or ‘ceiling’. This type of mortgage can also have a set lower limit, known as the floor or ‘collar’. For these mortgages the interest rate can move between these limits, but cannot fall below the collar or go above the cap. This product may carry an early repayment charge.
Is it right for me?
Yes – If you like to budget with some certainty, think mortgage interest rates might rise above the cap, or you want the security of knowing your payments cannot rise above a set level and would like to benefit from any fall in interest rates.
No – If you can find a fixed rate set at a lower rate than the capped rate, and you think rates are unlikely to fall below the level of the fixed rate deal.
These are fixed, but if rates fall you pay the lower rate. As their name suggests the rates of tracker mortgages change to follow ‘track’ changes in the base rate to which they are linked. So if the base rate increases by 1%, the pay rate will increase accordingly. Also if the base rate is reduced, borrowers will benefit from a lower pay rate.
Is it right for me?
Yes – If you want to be sure your mortgage rate falls by the same amount as the Bank of England base rate falls, but the drawback is the mortgage rate also rises in step when the base rate increases.
No – If you find yourself locked into a rate above the base rate, which may be higher than the standard variable rate.
Cash back deals
This is when lenders offer money back if you take out a particular product. However, nothing comes free in life and cash back mortgages may be weighed down with hefty penalty charges if you later want to change lender.
Is it right for me?
Yes – If you need a cash lump sum, for example to do up your home, or you expect the cash back to more than compensate for any rises in interest rates during the period when an early repayment charge may apply.
No – If you can manage without a cash back now and can get an alternative deal.
Current Account Mortgage
This is a development on the offset mortgage that merges your mortgage and current account together. As money goes into your current account, for example your monthly salary, this is offset against your mortgage balance, so reducing the interest you owe. The lender will agree with you the minimum amount you should ideally leave in your account each month. If you leave more in, you will pay less interest and may be able to pay off your mortgage earlier. If you leave less in, you will pay more for your mortgage.
Is it right for me?
Yes – If you’re prepared to have your monthly income paid into your mortgage account, or a current account with your lender.
No – If your income is irregular or you wish to keep your mortgage and bank accounts separate.
Under this type of mortgage the borrower is offered a discount off the lender's variable rate. The rate paid will fluctuate in line with changes in the variable rate. The discount applies over a set term.
Is it right for me?
Yes – If money is tight when you first take out the mortgage, but you are confident your income will increase.
No – If you won’t be able to cope if interest rates rise later on, increasing your payments.
TEN KEY QUESTIONS
You should ensure you can answer and understand.
•How much can I afford to borrow?
•How can I tell which mortgage rate is best?
•What is the best type of mortgage for me?
•How should I repay it?
•Can I make lump sum payments?
•Are there any redemption penalties?
•Does this mortgage come with insurance?
•What other charges will I have to pay?
•What happens if I can't pay?
•Do I understand the small print?
As of 31st October 2004 the Financial Services Authority (FSA) is responsible for the regulation of mortgage sales. The FSA is an independent body that regulates the financial services industry in the UK.
Key facts documents
Mortgage providers are now legally bound to present customers with a key facts document.
The Financial Services Authority (FSA), which regulates mortgages, says the key facts document should deliver clear, simple and user-friendly information to consumers about the mortgage offer.
The key facts document sets out the total cost of the loan - not just the headline interest rate - including any up-front fees.
Mortgage fees have been rising of late as providers reduce their headline annual percentage rates to attract new business.
Each new mortgage customer has to confirm that they have received the key facts before putting pen to paper.
The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.
Key Mortgage Terms you need to know
Below are some of the key mortgage terms you may hear. This list is not exhaustive, but should assist you in choosing the right mortgage deal.
Arrangement Fee - The amount that the lender will charge to set up the mortgage. These vary hugely. Some lenders will allow you to add them on to the mortgage but you will pay interest and lose equity in your property by doing this. Normally low rate deals have higher arrangement fees often making them worse than higher rate deals. There may also be booking fees, valuation fees and other miscellaneous fees.
Benefit Period - A period at the start of a mortgage where you get a 'special' rate offered by a lender, normally lower than their standard variable rate.
Buy to Let – When an individual purchases a property with the sole purpose of renting it to another party. This has been increasingly popular in recent years with specialist lenders springing up. Most lenders will have internal lending criteria and a certain rent will be needed to make a loan viable. Some lenders ask for minimal rental coverage eg 100% of payments. Others demand that the rent covers 130% of the mortgage payment. If using property as an investment make sure it is thus viable.
Capped - A mortgage product that will not increase above a certain percentage. For example "capped at 4%" would mean the rate could never be above this. This gives the borrower some peace of mind.
Cashback - When a lender offers a certain amount of cash on completion to the customer as an incentive to take out their product. It is important that this is taken for what it is. You should ensure that this is financially worthwhile and the deal does not suffer as a consequence.
Collared - A mortgage product that will not fall below a certain percentage. For example "collared at 4%" would mean the rate could never be below this. This gives the lender financial security but, may allow them to offer a slightly better rate.
Completion - The date when a mortgage comes into force, normally dictated by the solicitor.
Deferred interest - Allows a borrower to make payments at a later date. However, the capital owed will increase during the deferred period. E.g. deferred for 6 months means that you would only have to pay the capital element of the mortgage with the interest being added on each month.
Discount - When a mortgage is set at a specific % below the lenders Standard Variable Rate (SVR) e.g. if the lender has an SVR of 7% and the discount is -2% you would actually pay 5%.
Early Repayment Penalty (ERP) - The amount it will cost to either pay off your mortgage or leave a provider. These are often 2-3% of the value of the loan during an initial benefit period and are used by lenders to keep borrowers with them.
Equity – The value of your house minus any mortgages and secured lending that you have on it leaves what is called the equity. Remember this can also be negative if house prices fall.
Flexible - A mortgage with special additional features e.g. paying more or less than was initially agreed, making lump sum payments (overpayments), temporarily stopping payments (payment holiday). Each lender will have their own definition so make sure it meets your needs.
Guarantor - An agreement by a third party to pay a mortgage if the main applicant is unable to do so, often a parent for a first time buyer. This is a binding legal contract and should not be entered into without seeking legal advice. It can however, assist in reducing any Capital Gains Tax Liability because the guarantor only has an obligation to guarantee the loan rather than owning the property.
Homebuy - A government sponsored scheme that assists existing tenants to get on the property ladder.
Joint Tenancy - A type of ownership which entitles both owners to 100% ownership of the property. What this really means is that upon the death of either party ownership passes entirely to the survivor. By changing this ownership into 'Tenants in Common' under which each individual owns a % of the property you can make significant IHT savings. You should seek specialist legal advice on how to do this.
Key Features – This should be provided by a mortgage broker and provides details of charges made by the broker, rates and fees as well as other information.
Let to Buy – Otherwise known as shared ownership. Involves buying only part of a property and paying rent on the remainder. These allow some people otherwise unable to do so to get a foot on the property ladder.
Lifetime Mortgages - A means of older homeowners releasing money from their property. Normally called home reversion or equity release schemes there will be no monthly payments or fixed repayment date. However, the lender will expect money back when the house is sold reducing any potential inheritance or money available to buy a new house. The fees on these arrangements are often high and the value you will receive for your house may be below that of the market.
Mortgage Deed - The contract between the lender and the borrower. It sets down the legal obligations of the borrower and the rights of the lender.
Offset - A Special type of mortgage run side-by-side with a bank account. These are not appropriate for everyone. The way it essentially works is as follows: cash in your bank account does not receive interest but the amount of interest you pay on your mortgage is also reduced. E.g. If your Mortgage was £150,000 and you had £50,000 in the bank you would only pay interest on £100,000 of your mortgage. This can, dependent on the lender, be used to reduce your monthly payment or the term of the mortgage, saving huge amounts.
Porting/ Portable - This is a feature that allows a borrower to transfer borrowing from one property to another. This may mean that charges and fees are avoided or a special rate is retained. You can often "port" just part of a mortgage onto a new property.
Redemption Statement - Issued by your existing lender it shows exactly what you would need to pay, including all fees and interest owing, to pay off your mortgage.
Right-to-buy - Allows tenants in council houses to purchase their homes with a big discount.
Self-Cert - Often used for self-employed people, this means a lender agrees that the applicant can confirm their own income rather than providing all the necessary evidence i.e. P60, payslips, accounts.
Sub-prime, non-confirming, non-status - A Mortgage geared towards those with County Court Judgements (CCJs), poor credit history, or for those clients who have been bankrupt or in arrears. Rates are likely to be higher than those available in the market as a whole.
Term - The term chosen for the loan. The longer the term the more you will pay to the lender overall.
Valuation - Most lenders will request a basic valuation to ensure that a property is fit for mortgage. There will be a fee for providing this service. It is also possible to request a more detailed homebuyers valuation or a structural survey. These are more thorough investigations, performed by a specialist surveyor, of the state of the property and can ease your mind as a buyer. There is of course a charge for these types of survey and you should liaise with the lender to find out what each type of survey will provide.
Whilst every effort is made to ensure that the legal information contained on “YouandYourRights” is accurate, it does not constitute legal advice tailored to your individual circumstances. If you act on it, you acknowledge that you do so at your own risk. Neither the Proprietor nor Dean Dunham can assume responsibility and do not accept liability for any damage or loss which may arise as a result of your reliance upon it.