A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments.
Who Uses a Mortgage?
Individuals and businesses use mortgages to make large real estate purchases without paying the entire purchase price up front. Over many years, the borrower repays the loan, plus interest, until she or he owns the property free and clear. Mortgages are also known as “liens against property” or “claims on property.” If the borrower stops paying the mortgage, the lender can foreclose. They are a form of incorporeal right.
In a residential mortgage, a homebuyer pledges their house to the bank or other type of lender, which has a claim on the house should the homebuyer default on paying the mortgage. In the case of a foreclosure, the lender may evict the home’s tenants and sell the house, using the income from the sale to clear the mortgage debt.
There are two main types of mortgages:
- Fixed rate: The interest you’re charged stays the same for a number of years, typically between two to five years.
- Variable rate: The interest you pay can change.
Fixed Rate Mortgages
The interest rate you pay will stay the same throughout the length of the deal no matter what happens to interest rates. You’ll see them advertised as ‘two-year fix’ or ‘five-year fix’, for example, along with the interest rate charged for that period.
- Peace of mind that your monthly payments will stay the same, helping you to budget
- Fixed rate deals are usually slightly higher than variable rate mortgages
- If interest rates fall, you won’t benefit
- Watch out for charges if you want to leave the deal early – you are tied in for the length of the fix
The end of the fixed period – you should look for a new mortgage deal two to three months before it ends or you’ll be moved automatically onto your lender’s standard variable rate which is usually higher.
Variable Rate Mortgages
With variable rate mortgages, the interest rate can change at any time.
Make sure you have some savings set aside so that you can afford an increase in your payments if rates do rise.
Variable rate mortgages come in various forms:
Standard Variable Rate (SVR)
This is the normal interest rate your mortgage lender charges homebuyers and it will last as long as your mortgage or until you take out another mortgage deal. Changes in the interest rate might occur after a rise or fall in the base rate set by the Bank of England.
- Freedom – you can overpay or leave at any time
- Your rate can be changed at any time during the loan
This is a discount off the lender’s standard variable rate (SVR) and only applies for a certain length of time, typically two or three years. But it pays to shop around. SVRs differ across lenders, so don’t assume that the bigger the discount, the lower the interest rate. For Example:
Two banks have discount rates:
- Bank A has a 2% discount off a SVR of 6% (so you’ll pay 4%)
- Bank B has a 1.5% discount off a SVR of 5% (so you’ll pay 3.5%)
Though the discount is larger for Bank A, Bank B will be the cheaper option.
- Cost – the rate starts off cheaper which will keep monthly repayments lower
If the lender cuts its SVR, you’ll pay less each month
- Budgeting – the lender is free to raise its SVR at any time
If Bank of England base rates rise, you’ll probably see the discount rate increase too – Watch out for charges if you want to leave before the end of the discount period.
Tracker mortgages move directly in line with another interest rate – normally the Bank of England’s base rate plus a few percent. So if the base rate goes up by 0.5%, your rate will go up by the same amount. Usually they have a short life, typically two to five years, though some lenders offer trackers which last for the life of your mortgage or until you switch to another deal.
- If the rate it is tracking falls, so will your mortgage payments
- If the rate it is tracking increases, so will your mortgage payments
You might have to pay an early repayment charge if you want to switch before the deal ends. Watch out for the small print – check your lender can’t increase rates even when the rate your mortgage is linked to hasn’t moved. It’s rare, but it has happened in the past.
Capped Rate Mortgages
Your rate moves in line normally with the lender’s SVR. But the cap means the rate can’t rise above a certain level.
- Certainty – your rate won’t rise above a certain level. But make sure you could afford repayments if it rises to the level of the cap.
- Cheaper – your rate will fall if the SVR comes down.
- The cap tends to be set quite high
- The rate is generally higher than other variable and fixed rates
- Your lender can change the rate at any time up to the level of the cap
These work by linking your savings and current account to your mortgage so that you only pay interest on the difference.
You still repay your mortgage every month as usual, but your savings act as an overpayment which helps to clear your mortgage early