There are five main types of interest payment on either interest only or repayment type mortgages. On this page we will explain the workings of each of these interest charges.
Fixed rate mortgages have an interest rate that remains the same for a period of time – usually between 1 and 5 years. After this period of time the interest rate reverts to a variable rate. The fixed rate is usually at a discount as an incentive to take out the mortgage.
The advantage of fixed rate mortgagees is that there are no surprises for the duration of the fixed rate. It helps many borrowers who would like to budget, giving them security of knowing their payments won't change. The downside to this type of mortgage occurs if the Bank of England base rate or Libor rate falls, in which case you could end up paying more than you would have with a variable rate mortgage. Also if you want to leave before the agreed term the early repayment charge is usually significant. For example, you may be charged six months gross interest if you leave a five-year fixed rate agreement – this can be many thousands of pounds.
Please visit our Mortgage sourcing pages to see some examples of the types of mortgage product to which this refers.
With a variable rate mortgage, the interest rate varies according to the Bank of England base rate or the Libor rate. A lender's variable rate is set above the base rate by usually 1 or 2%.
With this type of mortgage the upside is the same as the downside; the interest rate can go down, saving you money, or up, in which case your interest payments increase.
With a Bank of England base rate tracker, the interest rate you pay is linked to the Bank of England base rate as opposed to the lender’s standard variable rate. The rate is dependent on the deal you take. The rate is usually set anywhere between 0.59% and 1.5% above the base rate and can last for one to two years, or in some instances the lifetime of the mortgage. Unlike a discount mortgage, if the bank of England base rate reduces, your payment must also reduces in line with it. The same is also true if the bank of England base rate goes up. Your payment would also increase.
Therefore interest savings are passed on to you immediately. In many instances we have found clients who have a discounted mortgage and the bank of England reduce their rates, but the borrower's lender are very hesitant to reduce their rates. This can cost the borrower much more in interest over the term of the mortgage.
Discounted Variable Rates – As the name suggests, to tempt new customers, lenders will offer a variable rate at a reduced initial rate or below their standard variable rate. After the agreed period, again one to five years typically, the rate reverts to the lender’s standard variable rate.
The interest rate during the discount period will go up and down in line with the standard variable rate. Disadvantages of this type of mortgage are obviously that the rate can go up and there are penalties for leaving early. It is possible that penalties may be charged for a period longer than the discount period. This is called overhang.
Flexible Rates – As the name suggests, this type of product is highly flexible. The rate can either be discounted, fixed or a Bank Of England base rate tracker. Rates on these products tend to be a little higher than on discounts but the advantages can well outweigh the higher rates. The beauty of this product is that overpayments, underpayments, payment holidays, Access to additional credit and Savings offsets can be achieved. However, not all lenders of Flexible Mortgages are fully flexible as many don't allow offsetting savings for example.
This type of product can benefit numerous types of people. For Example people who are self employed and may earn sums of money on an irregular basis can pay more into the mortgage during this period and then reduce payments during leaner times.
People who are considering carrying out work on their property in the future can take advantage of having a credit facility available. This can save considerable time and money as additional loan applications don't have to be arranged.
The big winners are people who have savings. Many of us pay tax on savings at either Basic or Higher rate. The good flexible mortgage allows savings to be offset against the mortgage but the savings can still be withdrawn by phone call or internet banking.
How would you like to have Tax Free Savings? Rather than earn interest on your savings, the money in your savings facility would be used to reduce the interest charged on the mortgage. You can build up the savings facility by paying in deposits via telephone, internet or post, or by overpaying on their mortgage. Savings can also be used to fund underpayments or payment holidays without increasing the mortgage balance.
As no interest is paid on your savings facility, no interest will be charged on the equivalent amount on their mortgage. Therefore, if you have an initial mortgage loan size of £70,000 and savings of £5,000 you will only be charged interest on £65,000.
This means that your saving facility is free of income tax.
For example, with a mortgage rate of 4.25% pa, the gross rate your client would need to earn on their savings would be a rate of 5.31% pa if they are a basic tax payer, and 7.08% pa if they are a higher tax payer in order to earn a comparable rate*. How many of us are earning these rates on our savings?
For further information about interest rates on mortgages please contact us.
*information correct at time of production 30th September 2003.
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