Mortgages: Two Main Choices
Mortgages are particular types of secured loans. There are different types of mortgages, the differences mostly being about the choices you have over:
- the way you repay what you borrow, and
- how interest is calculated
All mortgage repayments usually consist of two parts: repayment of the amount you borrow, and interest payments. Over the life of a typical mortgage (say, 25 years) the interest payments can be as much as twice the amount you borrow, even more in times of high interest rates. Both are substantial costs, so the choices you make can have a significant effect on the amount of money you pay.
Options for repaying what you borrow
1 - Endowment Mortgages
Endowments are combined investment and life insurance policies. You pay a regular amount of money into them, your money is invested and, at the end of the policy, it pays you back the growth resulting from that investment.
Because the final amount is unknown, there is a risk with Endowment Mortgages: the final sum you get back may be more, or less, than the money you originally owed. If it is less, you will have to find the remaining money from alternative funds.
2 - Repayment Mortgages
The money you owe on Repayment Mortgages is paid back in monthly instalments so that, by the end of the mortgage, all the money you owe is paid off.
3 - Interest Only Mortgages
The money you owe on Interest Only Mortgages is not paid back at all (at least, it is not included in the monthly payments). You leave the same amount of debt outstanding for the duration of the mortgage.
In such situations you will have an alternative plan for paying off what you borrow. For example, there are particular types of interest only mortgages called "bridging loans". These enable you to buy a second house whilst you have not yet sold the one you currently own, so that you can renovate the second house and then move in. You only repay the money owed on the bridging loan once you have sold your first house, using the money you get from that sale.
4 - ISA Mortgages
An ISA is a special savings or investment account that qualifies for tax relief. You pay a regular amount of money into the ISA, the amount you have saved is invested, and the value of the ISA is used at the end of the mortgage to pay back the money you borrowed.
As with Endowment Mortgages, the final amount of the ISA fund is unknown, so there is a risk that you get back more or less than the money you originally owed, with the possibility that you may have to make up a shortfall.
5 - Pension Mortgages
Pension mortgages are similar in principle to ISA and Endowment Mortgages: you pay money into a fund, which is invested, and at the end you get a lump sum that is used to pay off the mortgage. In this case, you pay money into a pension fund.
However, the amount of money that you can pay into the fund, and draw off at the end to pay off the mortgage, is governed by a different and much more complex set of rules to ISAs and Endowments, because it is a pension scheme.
Different ways of calculating interest
Whatever type of mortgage you choose, monthly interest payments will usually be larger than monthly payments made to pay off the loan. You may or may not be able to see this in your bank statement. With an endowment mortgage, you will normally see the payments from your bank account being made separately: ie there will be one transaction for interest payments, and one for the endowment policy. With a repayment mortgage, the monthly payments are usually combined into a single bank account transaction. Nevertheless, interest payments are usually the larger part of the mortgage, so the choice of interest calculation can make a big difference to the overall cost.
1 - Tracker Mortgages
Monthly payments can change frequently with tracker mortgages. This is because the monthly amount you pay goes up and down as interest rates go up and down.
The rate of interest used in tracker mortgages is usually set slightly above a base rate that is "tracked", such as the Bank of England's base rate. So, if the Bank of England's base rate is 4%, the mortgage lender may set their rate at 4.75%. Any change in interest rate is applied automatically, immediately or very quickly after the change, so the monthly payment changes also changes quickly.
2 - Variable Rate Mortgages
These are sometimes referred to as "standard variable rate mortgages", and the monthly payments can change occasionally.
They are quite similar in concept to tracker mortgages, except that the monthly amount you pay back does not go up and down automatically and immediately, but only as the mortgage lender decides to move its interest rates up and down, and the change is implemented in the timescale they decide. The change may be left until the end of specified periods, sometimes as infrequent as annually. Standard variable rate mortgages are often the most expensive type of mortgage available.
3 - Fixed Rate Mortgages
Fixed Rate Mortgages are usually offered for a specific number of years, and during that period your rate of interest, and therefore your monthly payments, do not change, irrespective of general interest rate movements.
After the initial fixed-rate period, mortgages often revert back to being variable rate (an expensive mortgage), though you often have the option of asking the lender to switch to another fixed-rate mortgage.
4 - Discount Mortgages
Discount mortgages provides a discount - ie you pay less - for an initial period of the mortgage. These are usually variable rate mortgages, so the monthly payments can still go up and down in line with interest rates. However, you still pay less than you would otherwise have paid.
5 - Capped Mortgages
This is a special form of variable mortgage where rates can go up and down but, for an initial period of the mortgage, there is a ceiling. That is, there is a maximum rate above which your mortgage will not go. Your monthly payments will therefore vary, but never be greater that a certain amount (the 'cap') because if interest rates go above the cap, then you only pay the capped rate, not the (higher) variable rate.
There are various other features that may be offered with a mortgage that are not directly related to how you pay the mortgage back, or how interest is calculated.
In a cashback mortgage the lender gives you some additional cash at the start of the mortgage. So, whilst the mortgage can be used to buy a house, the additional cash can be used to buy furnishings etc..
A cashback mortgage is usually more expensive than other mortgages, and/or has additional penalties if you switch to another mortgage provider before the end of the mortgage.
A flexible mortgage is one that allows you to vary your monthly payments. This usually includes:
- Making extra payments so that you pay off your mortgage early, thereby saving money
- Taking 'payment holidays', ie for a certain number of months you do not have to make a payment, thereby helping you with extra cash in the short term
Some mortgages offer other flexible features, such as:
- Mixing some elements of fixed rate and others of variable rate in the same mortgage
- Linking your mortgage and your savings, to 'offset' interest payments. As mortgage interest payments are normally higher than interest payments made to you on savings, this 'offsetting' can save you money.
As a general principle, the cheaper the mortgage, the greater the penalties should you decide to change your mortgage to another provider.
The conditions and amount of penalty can change over time (usually getting smaller).
The penalty is usually a cash amount that you have to pay the mortgage lender. As a rough guide, a typical penalty is three times your monthly payment, but it can be more or less, as defined in the terms of the mortgage agreement.
Most mortgages are offered on the basis of financial references, either from your employer confirming your salary, or if you are self-employed from your accountant giving previous years accounts history to show how much you have drawn from the business.
In some circumstances it is not possible to provide these financial references; if, for example, you are self-employed but in a growing business, your history of drawings may be much lower than necessary to support a mortgage that you could afford.
Self-certification is a self-declaration of your personal income, and the lender takes your statement on trust. There are only certain lenders who offer self-certification mortgages and they are usually more expensive, because there is a greater risk for the lender.
The types of mortgages available are defined, in general, by the way the money is repaid, and how interest is calculated.
Money can be repaid by one of the following methods:
- Interest Only (ie no repayment)
Interest is calculated by one (or more) of the following methods: