Understanding mortgage types and interest rates
Interest rates play a big part in your monthly mortgage payments, therefore understanding how they work, and the different types of rates, can be essential before going ahead with a mortgage.
Below we have highlighted the different types of interest rates and how they will affect a mortgage. This is so you can ensure you are making the right decision when applying for a mortgage or looking to remortgage to a new product.
- What is an interest rate on a mortgage?
- What is the Bank of England base rate and how does it influence my mortgage rate?
- What is a fixed-rate mortgage?
- What is a variable rate mortgage?
- What is a standard variable rate mortgage?
- What is a tracker rate mortgage?
- What is a discounted rate mortgage?
- What is an offset mortgage?
- What is a capped rate mortgage?
- What is an interest-only mortgage?
- How to ensure you are choosing the right mortgage type
What is an interest rate on a mortgage?
An interest rate on a mortgage is a percentage of how much you have borrowed added on as a fee you must pay over the course of your mortgage. It’s essentially the cost passed on by your lender for borrowing money.
The interest on a mortgage loan is incorporated into your monthly mortgage payments. Therefore, the lower the interest rate you get, the cheaper your payments will be.
Interest rates are set by your lender and can follow or be influenced by the Bank of England base rate. Not everyone will be offered the same rate of interest, this is because a lender will assess your circumstances to determine how much of a risk you are to lend to.
The riskier you are, due to things like bad credit or a smaller deposit, the more chance you have of being offered a higher rate. This works both ways, however, if you have good credit and a larger than average deposit, you could unlock much more favourable rates.
What is the Bank of England base rate and how does it influence my mortgage rate?
The Bank of England base rate is the interest rate at which the Bank of England charge other financial institutions to borrow money. Therefore, it plays a crucial part in influencing the interest rates charged by mortgage lenders.
If the base rate goes up, it’s likely that mortgage interest rates will follow the pattern and go up too. And if it drops, then it’s likely that mortgage interest rates will drop too.
If your term has a variable mortgage rate, then the interest on your loan will fluctuate in accordance with the base rate. However, if you get a fixed rate mortgage product your interest rates will be fixed, hence the name. Therefore, any changes in the base rate will have no effect on your interest rate.
What is a fixed-rate mortgage?
As we have briefly mentioned above, fixed-rate mortgages involve the interest staying the same for the length of your deal. Therefore, your monthly payments will stay the same throughout this duration.
It’s most common to fix your mortgage for 2, 3, or 5 years, although it is possible to fix it for longer than this. Some lenders may allow you to fix it for up to 10 years.
- As your monthly payments will stay the same no matter what the market does, it can be much easier to budget.
- If general interest rates rise you wouldn’t be affected.
- On many fixed-rate mortgages, you can typically contribute extra to your loan without being charged a fee. Although, lenders will usually impose a maximum amount on how much you can repay without incurring a fee. This maximum amount is usually around 10% of your total loan.
- As your rate won’t change, even if overall mortgage rates increase, lenders usually price fixed-rate mortgages slightly higher than something like a variable rate product.
- If the base rate was to decrease, then you wouldn’t benefit from any savings in interest. Therefore, over a long period your costs could be much higher.
- If you wanted to leave your fixed-rate product early then it’s likely that a lender will charge you an Early Repayment Charge (ERC), making them less flexible than a variable rate product.
What is a variable rate mortgage?
Unlike a fixed-rate mortgage, a variable rate mortgage will be guided by the changing interest rate, and so will fluctuate over time. This is usually in line with the Bank of England base rate.
If the base rate goes up, then it’s likely that so will your interest rate, in turn making your monthly payments more expensive. And this works the other way if the base rate was to drop. Furthermore, if the base rate is to stay the same then so will your interest rate on your mortgage.
There are three types of variable rate mortgages: standard variable rate, tracker rate, and discounted variable rate.
- These mortgages are much more flexible than a fixed-rate product. This is because there is usually no ERC when leaving a variable rate mortgage, making it much easier to switch product if needed. However, always check with your lender before going ahead with anything, as this can avoid confusion.
- Variable rate mortgages can prove much cheaper than a fixed-rate product. If interest rates are to decrease, so will your payments. Therefore, they can be a good choice if you believe that rates will decline in the near future.
- There is always a risk of overpaying for a variable rate mortgage. This is because if interest rates are to rise then so will your mortgage payments, no matter how long it lasts or how high they reach.
- Due to the unpredictable nature of these mortgages, it can make it hard to budget as you never know when your mortgage products rate may increase or decrease.
What is a standard variable rate mortgage?
A standard variable rate (SVR) mortgage is a type of variable rate mortgage offered by most lenders in the UK. These products are usually influenced by the current base rate; therefore, they will fluctuate in accordance with the market.
An SVR mortgage is the standard product that a lender will offer their customers. For example, if your fixed-rate product ends then it’s likely that you will revert to your lenders SVR product.
Every lender will have a slightly different SVR, and this rate is generally higher than the majority of their other mortgage products. Certain lenders may increase their SVR up to 5% more than the Bank of England base rate.
- The main benefit of having an SVR product is that you can leave at any time without having to pay an ERC. Therefore, these types of products can be seen as quite flexible.
- If interest rates decrease then you could benefit from a lender decreasing the SVR, making your payments cheaper and saving you money.
- Most lenders will allow you to make extra payments to your mortgage, known as overpaying, without imposing a maximum limit.
- Compared to other variable rate products or other mortgage products in general, SVR mortgages usually have higher interest rates.
- Your interest rate can change at any time; therefore, it can be hard to budget. It also means that your mortgage payments could become expensive if the base rate were to see a big increase.
What is a tracker rate mortgage?
A tracker rate mortgage is another type of variable rate mortgage where the interest rate tracks a specific benchmark. In the UK, this benchmark is most likely going to be the Bank of England base rate. Therefore, the interest on your mortgage will move up, down, or stay the same depending on what the benchmark is doing.
For example, if the Bank of England base rate was used as your tracker rate and it decreased by 1%, then so would your mortgage interest rate.
Typically, tracker rates last anywhere from 2–5 years, although it’s possible to get tracker rates that last for your whole mortgage term. However, keeping a tracker rate for this long may not be the best idea as there is always the chance that the base rate can increase significantly.
- If the rate your mortgage product is tracking goes down you can benefit from a cheaper interest rate, therefore decreasing your monthly payments.
- This type of product usually has no tie-in period, meaning you can switch products or lenders without incurring a fee. This makes tracker rate mortgages a flexible option for borrowers.
- If you have a tracker rate mortgage, it usually means that you can benefit from making overpayments without being charged a fee. This can allow you to reduce the overall amount of your loan, without having to pay extra like you may have to for other mortgage types.
- If the rate your mortgage product is tracking increase, then so will your mortgage payments.
- The fluctuation in interest rates can cause uncertainty and make it much harder to budget.
What is a discounted rate mortgage?
A discounted rate mortgage product is a type of variable rate mortgage where the interest rate charged is set at a percentage below the lenders SVR. The discount you may be offered will be for a fixed period, after which your rate will typically revert to the lender’s SVR.
These products usually last a short period, around 2–3years. As every lender’s SVR is different, it doesn’t mean that the lender offering the biggest discount is always the cheapest.
For example, a lender with the highest SVR in the market could be offering a large discount and a different lender could have a lower SVR, but offering a slightly smaller discount, however their discounted rate would still be lower.
- If the market is in a good place, with a low base rate, then you can unlock some of the cheapest mortgage rates in the market.
- As your rate is a discount of a lenders SVR, if their SVR was to decrease you will benefit from this reduction in cheaper payments.
- Discounted rate mortgages usually offer limited flexibility, meaning you cannot leave the term early or make overpayments without incurring a penalty fee.
- There is always the risk that your interest rate could increase due to the base rate increasing. This uncertainty can make it hard to budget.
- Once the term ends its likely that you will be placed back on to a higher interest rate, this will likely be the lender’s SVR.
What is an offset mortgage?
An offset mortgage is a type of product in which your outstanding mortgage balance is offset against your savings or current account balance held with the same lender. Your lender will calculate the difference between your mortgage balance and your savings balance to determine what part of your loan you pay interest on.
In turn, this means that you will be charged less interest than other types of products, making your monthly payments cheaper.
For example:
Your outstanding mortgage amount is £250,000 and you have £25,000 in a savings account.
Therefore, you would only pay interest on £225,000 of your mortgage, instead of paying interest on all £250,000.
In turn, this means you would make a 10% saving on the amount of interest you would pay on your mortgage.
- You can still make deposits and withdraw money from your savings account even if it’s linked to your offset mortgage.
- The interest you save through an offset mortgage isn’t taxed.
- You could pay off your mortgage quicker than with another mortgage type, as the more money you have in your savings the lower your payments will be.
- You won’t make any interest on your savings account – although the interest you save on your mortgage could outweigh the interest gains you could make on a normal savings account.
- It is possible that other savings accounts elsewhere could offer you better savings, therefore you will need to shop around to ensure you are choosing the right product.
- Interest rates on offset mortgages can sometimes be higher than other mortgage types. Presenting yourself as a less risky borrower can allow you to unlock cheaper rates. This can be done through things like providing a larger deposit or having a good credit history.
What is a capped rate mortgage?
A capped rate mortgage is another type of variable rate mortgage product in which the maximum interest rate you will pay is set in advance. This means that even if the base rate were to increase, you may not be affected by it as your interest will be capped.
However, you can still be impacted by an increasing base rate if it doesn’t exceed your agreed maximum rate.
Typically, these mortgage products will last between 2–5 years and once they finish you will be reverted onto a lender’s SVR mortgage product.
- The added security of having a cap on your interest rate can give you peace of mind, as well as save you money if the base rate were to significantly increase.
- You will also still benefit from any decreases in the base rate; therefore, you would make savings like someone on another type of variable mortgage product would.
- Budgeting can be easier than other variable rate mortgage products as you known the maximum rate in which your mortgage could be charged at.
- Even though your limit is capped, if the base rate were to exceed this cap you will still be paying the higher amount of interest on your mortgage as a lender will charge you the capped amount.
- Mortgage fees are likely to be higher on these products, as lenders are sacrificing the money they would make on interest payments if rates were to increase. Furthermore, it is possible that lenders will also offer a higher initial rate to cover themselves.
- These products usually incur early repayment charges, meaning if you want to leave early you will need to pay a pre-arranged fee to your lender. This can be anywhere from 1–5% of the remaining loan amount.
What is an interest-only mortgage?
Interest-only mortgage products only require you to pay back the interest on your loan each month, rather than paying the outstanding loan amount too. In turn, this will make your mortgage payments cheaper each month. Therefore, they are a great way to cut down costs in the short term.
Although, you will need to remember that at the end of the term you will still need to repay the full outstanding loan amount. Borrowers will invest the money they are saving on mortgage payments, in hopes that they can make more out of it, and then look to repay their mortgage at the end of the term. This is known as a ‘repayment vehicle’ and they are required by a lender to obtain an interest-only product.
It’s common for Buy-to-Let mortgages to be set up on an interest only basis, therefore the landlord can decrease their monthly costs and maximise their rental profits in the short term.
- Your monthly payments will be kept at a minimum, therefore this can free up cash flow and allow you to allocate income elsewhere.
- If the saved money you invest performs well, you can make a profit when you come to repay the loan amount as you could have money left over.
- If your repayment vehicle doesn’t provide a sufficient return, and you can’t repay your mortgage at the end of the term then you may be required to sell the property to raise the funds.
- As well as thinking about your mortgage, you will also need to keep in mind your repayment vehicle.
How to ensure you are choosing the right mortgage type
With such a wide variety of mortgage types to choose from it can be hard to navigate the market and know what is best for you. While you can do your own homework and use comparison websites, it can still be hard to property understand what you want from a mortgage.
That’s why using an expert mortgage broker can prove invaluable. A broker will be able to understand your circumstances and needs to determine the most suitable product option for you. They can also pair this with their connections to lenders, to find you the most competitive deals.
If you are looking to change your mortgage product type or just get a mortgage, reach out today! Our team of specialist advisors are on hand to discuss your situation over a free no-obligation consultation.
Phil Scott
Director
About the author
Phil has worked in the financial services industry since 1992, having started with a large insurance company. He went self employed in 1996 as an Independent Financial Adviser before setting up his first company, Needham Market Home Financial in 1999.
After four years, he decided to concentrate solely on mortgages and related insurances, and The Mortgage Centres was born. Since then, Phil has been influential in the opening of several new offices as the business continues to grow.
Qualifications
Financial Planning Certificate: 1,2 & 3
Year Attained: 1992
Certificate in Mortgage Advice and Practice (CEMAP)
Year Attained: 2001
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