Types of mortgage
With so many different types of mortgage to choose from - it can be easy for homeowners, or potential homeowners to get confused. Know Your Money have put together this guide looking at the details of each available mortgage so that you can make an informed decision on what's right for you. Click on the mortgage type you're interested in below to learn more about it.
What is a repayment mortgage?
In a repayment mortgage - or capital repayment mortgage, the aim is to gradually repay all of the money you borrowed to purchase your home, over your chosen mortgage term. Usually, the agreed term for most people is 25 years, but longer and shorter terms can be arranged. At the end of the agreed term there will be no outstanding debt of either the capital borrowed or interest accrued, so long as all of the repayments have been met.
People with a repayment mortgage make a single contribution each month to their lender. Part of that payment goes towards paying off the interest on your loan, while another part is allocated to paying down the capital that was originally borrowed. Lenders tend to weight the balance between the two so that earlier repayments are mostly interest, with very little going towards the capital investment. Over time the balance will shift.
What is an interest-only mortgage?
With an interest-only mortgage, your monthly repayment covers just the interest that you owe on the debt - none of the capital is paid off. This will mean that you need to make other arrangements to ensure you're prepared to pay back the capital you owe at a later date.
Usually, borrowers will look for an investment fund to help them out here, either using monthly payments into an investment plan, or with a lump sum invested in a fund at the start of the mortgage term.
There is some risk involved with taking out an interest-only mortgage, as there is no guarantee that your investment vehicle will generate enough to pay off the mortgage in full by the end of your term. If the gamble doesn't pay off, you end up dealing with a shortfall when you need to repay the cost of your property.
If you are unable to raise the required funds or extend your mortgage term your property will be at risk of repossession.
What is a fixed rate mortgage?
Fixed interest rates can be applied to any type of mortgage. They simply ensure that the interest rates you pay on your mortgage, and thus your monthly repayments, remain the same over an agreed term period - which usually ranges from one to ten years.
During the agreed term the interest rate on your mortgage loan will not change, regardless of how economic conditions or the Bank of England's base rate evolve during that time, as long as the terms and conditions set out by the lender are upheld. They are a good option to consider when the Bank of England's base rate is low as this low rate of borrowing should also be reflected in your lender's rates.
Fixed interest rates are usually lower than variable rates as they are designed to lock a borrower in with a lender. There will usually be financial penalties incurred if a borrower moves from one lender to another during a fixed term.
At the end of a fixed term, the interest rate will switch automatically to the bank's standard variable rate. At this point the mortgage holder can continue with the standard variable rate, negotiate a new fixed term with their current lender, or seek a new mortgage deal with another lender.
What is a standard variable rate mortgage?
Just like a fixed interest rate mortgage, a standard variable interest rate can be applied to any type of mortgage. The rate can fluctuate at the lender's discretion and will generally change as a reaction to economic conditions and the Bank of England's base rate. That means your monthly payments can go up or down.
A standard variable interest rate will usually be higher than the typical offerings on the market when you start searching for mortgages. However, some mortgage lenders offer 'capped' standard variable rates. These ensure that the interest rate will not increase by more than a maximum increment, will not rise above more than a set level, or will only change once during a certain period time.
Each bank usually has one standard variable rate which is universal to all of its customers. However, some lenders will offer discounts to the standard variable rate for some customers, typically those within the early years of the mortgage term when the affordability levels are typically lower.
What is a tracker rate mortgage?
Tracker rate mortgages are basically a form of variable rate mortgage. What makes them different from the standard variable rate mortgage, is that they track the movements of an economic indicator - usually the Bank of England base rate.
Though a tracker mortgage rate will not match the rates it is tracking, they will be given at a margin above that rate. Usually, introductory offers will provide a lower margin - such as the base rate plus 1%, whereas longer-term tracker mortgages often have a higher margin.
The theoretical benefit of a tracker rate mortgage is that your mortgage will reflect the performance of the economy overall: when the economy is in a state of good health, with stable growth in wages, high levels of employment and sustainable inflation, then higher mortgage interest rates will be affordable. However, if the economy declines and uncertainty increases, your mortgage payments will also decrease to lower your exposure to the risk of default in the event of unforeseen personal circumstances.
Tracker mortgage rates can be accessed for an introductory period of between one and five years, or they may be accessed on a 'lifetime' basis - which means that you continue to pay according to the fluctuations of the economy for the duration of your mortgage term.
What is a buy to let mortgage?
Buy to let mortgages are designed to allow private landlords to borrow money to buy property which they then rent out to tenants. They are therefore an example of a commercial mortgage. Although the applicant's credit history will be a factor in whether or not the buy-to-let mortgage application will be approved, there is less reliance on the income that the applicant receives, unlike a mortgage for a primary residence. Instead, the approval process rests largely on the rental value of the property exceeding the monthly cost of the mortgage repayments. A rental value of 125% of the mortgage repayment is commonly stipulated.
Lenders may also require the applicant to take out suitable landlord's insurance to protect the value of the property against damage and to cover the mortgage repayments during any periods when the property is not let.
A normal mortgage for a primary residence can be effectively turned into a buy to let mortgage by completing a consent to lease process with the lender.
What is a low deposit mortgage?
Low deposit mortgages, or 5% deposit mortgages, are designed to help more people on to the property ladder. They are taken up largely by first-time buyers, and they allow people to purchase a property while only paying a very small percentage of the overall purchase price upfront. This results in a high loan-to-value ratio (LTV).
Mortgages with high LTVs have been specially devised in response to rising house prices and an uncertain economic climate. Together, these factors had led to a shortage of opportunities in the home lending market for first-time buyers and those that had not yet built up significant levels of equity in their property. To ease these restrictions, a number of government-backed schemes have been created, including the Help to Buy schemes, which help people to obtain a mortgage with only a 5% deposit, and thus secure a 95% LTV.
Some lenders have also created their own low deposit mortgages that are unrelated to the government schemes. These became less common in the wake of the latest recession, but are finally coming back, although they will still tend to require an exemplary credit record and stringent affordability checks. They can sometimes include the provision of a guarantor agreement.
What is a remortgage?
A remortgage takes place when a property owner decides to move the mortgage on their property into a new agreement - either with a different lender, or the same one. This term can also be applied when homeowners take out a mortgage on a property that they own outright, in order to release equity.
Mortgage holders most commonly remortgage at the end of their fixed term, when their mortgage agreements move to a standard variable rate term. However, it is almost always possible to remortgage at any time, even during a fixed term. Although there will usually be early exit fees when leaving a fixed term, which must be paid to the existing mortgage provider - and these can be significant - it may still be financially beneficial to remortgage as the savings in doing so can outweigh the fees.
What is a cashback mortgage?
A cashback mortgage provides the applicant with a lump sum payment when the mortgage is fully agreed and has commenced. The level of cashback differs from lender to lender and is either a set sum (usually around £500 to £1,000) or a percentage of the overall mortgage, typically anywhere from 1% to 4%.
The cashback arrangement is an instrument designed to help people meet the costs of moving home or furnishing their new property if they've spent all of their budget meeting deposit requirements and paying mortgage fees. Cashback mortgages can, therefore, allow people to use all of their available cash funds either to meet the very minimum deposit levels required to obtain a mortgage, or to qualify for a cheaper interest rate as a result of meeting a lower loan-to-value (LTV) ratio.
The cashback that is provided does not usually increase the capital borrowed for the mortgage. However, the cashback will influence the overall affordability of the mortgage, and may be reflected in higher arrangement fees or interest rates compared with the standard mortgage deals available on the market. Over the whole course of the initial fixed term of the mortgage, these additional costs could be in excess of the lump sum that is paid out as cashback, meaning the cashback mortgage represents poorer value than other options.
Cashback mortgages look to be in decline. They are still available, but the number of offers and the average sums offered are falling.
What is a discount mortgage?
A discount mortgage is a form of variable rate mortgage. The term 'discount' applies because the interest rate is generally set at a lower rate than the standard variable rate of the lender - at least for an initial period. The discount may either take the form of a reduction in the interest payable on the capital payments, or remove the obligation to make repayments completely for a small period of time.
These types of arrangements are designed to help people meet the costs of establishing their new home, to balance other debts that they have incurred as a result of the mortgage and home buying process, or to help them build up reserve funds to ensure that they will be able to service their mortgage in the future, without going into arrears, in the event of unforeseen financial distress.
While discount mortgages tend to offer attractive deals in the short term, because the discount rate is offered according to the lender's SVR (standard variable rate), a discount mortgage may not offer a lot of stability in the longer term. What's more, as with cashback mortgages, the cost for accessing initial discounts may range from increased fees, to higher term lengths, or higher interest rates in the future.
What is a shared ownership mortgage?
Shared ownership mortgages involve properties that are generally sold through third-parties, such as housing associations. The would-be buyer purchases a stake of 25% to 75% of the property that they want, while the third party pays for the remaining share. Most of the time, the individual then lives in the property, and pays rent according to the remaining share that they do not own. This can help people to enter the property ownership market if they are unable to meet the deposit requirements for the full property value.
Shared ownership schemes are offered by the government, through local housing associations, and by private institutions such as property developers and investment companies. Individuals can usually take measures to buy the remaining share of the property during the course of the mortgage, or when the mortgage ends, either through gradual instalments or lump sums.
The partnering organisation in your shared ownership scheme can stipulate that particular lenders are used for the mortgage associated with the arrangement, and lenders sometimes set out specific mortgage deals for servicing them.
What is an offset mortgage?
An offset mortgage allows you to use your savings to reduce the amount of interest you pay on your mortgage. The balance of your savings accounts, and sometimes current accounts, is deducted from the total debt of your mortgage and the resulting figure is the one which interest is charged on within your monthly repayment. For example, if you have a mortgage of £100,000 and savings of £15,000 you would only have to pay interest on £85,000.
Your monthly repayment remains the same as it would have been on the whole amount borrowed, but more of it goes towards paying down the debt, rather than servicing interest. That means your mortgage will be paid off earlier than the full term, saving you from paying additional interest and relieving the burden of paying monthly mortgage payments later in your life.
Ascertaining whether or not an offset mortgage will be economically efficient in your circumstances is a difficult equation, with many variables potentially affecting the value of the deal as you move through the term of your mortgage. Mostly, though, it depends on your level of savings and the additional costs that you face with an offset mortgage as opposed to a regular mortgage.
You have to calculate whether the interest you would pay with the offset interest rate on your offset debt would be less than the interest you'd pay with the regular mortgage rate on the whole debt, remembering to factor in the interest you'd earn if you had your capital in a normal savings account that is unconnected to the mortgage. For instance, the interest due on a 5% offset mortgage debt of £85,000 mortgage could be more than the interest payable on a 4% mortgage at £100,000, and with the latter, you would still have the ability to earn additional interest on the other £15,000.
You will lose the ability to earn interest on any savings as you normally would when you use them as part of an offset mortgage. However, the tax benefits and long-term potential for a positive impact on your mortgage costs, can often balance this out.
Some offset mortgages include fixed terms within which time you can't withdraw or increase your savings. Others allow you to withdraw and pay in at any time. If you need to withdraw a large amount of your savings, the efficacy of your offset mortgage arrangement will be reduced.
With some offset deals, the total funds across all of your savings and current accounts are factored in. Others are limited to certain accounts.
What is a current account mortgage?
A current account mortgage is an example of a flexible mortgage. It works in a similar way to an offset mortgage in that the more money available to you which you don't use, the less interest you pay on your mortgage.
Though they work very similarly, there is one subtle yet discernible difference between what is usually classed as a current account mortgage and one that is usually classed as an offset mortgage. Where offset mortgages link accounts together, with the balance of one affecting the interest charged on the other, current account mortgages usually amalgamate the mortgage and current account to become one single account, effectively treating the mortgage debt as a large overdraft which can be paid off and borrowed again flexibly.
The maximum debt level may be set higher than what you initially borrow in order to facilitate use of extra funds earlier in the mortgage term. However, you will usually require a healthy equity level in order to qualify for such an arrangement. Otherwise, your maximum borrowing level would sit at your initial mortgage debt and you would then only be able to borrow extra money after you've begun to pay down the capital debt.
What are mortgage reserves and 'borrow back' mortgages?
A mortgage reserve is a flexible mortgage arrangement which is a variation on the offset mortgage and current account mortgage, combining elements from each. Though not always the case, mortgage reserves generally keep your mortgage and current accounts separate but allow you to borrow extra money from your mortgage and repay it flexibly, as you choose.
It therefore effectively acts as an overdraft which is guaranteed at the same interest rate charge as the mortgage. You will require equity on your property in excess of your maximum borrowing level, combining the mortgage and available reserve, in order to facilitate this arrangement. This means that sometimes you can only borrow the amount that you have already reduced your capital debt by through your monthly repayments so far within your term. This arrangement is sometimes referred to as a 'borrow back mortgage'.
The negative is that increasing your debt level means you will owe more in interest, increasing your monthly repayment or the overall repayment term of your mortgage.
What are self certification mortgage?
Self-certification mortgages were designed to allow self-employed people to obtain funding for home loans on their primary, private residence. They worked by allowing the applicant to submit their own calculations of their income, without the same burdens of proof required for regular mortgages for employed people.
Today, self-certification mortgages have been banned in the UK, but can still be offered by other lenders throughout Europe. Today, most self-employed people apply for the same mortgage products as everybody else, and simply provide a history of their accounts - usually at least two years' worth, and often with backing accreditation from accountants.
Self-certification mortgages were banned because of concerns that borrowers were being given mortgages that they couldn't afford to pay off. Now, all lenders must be sure that the borrowers they give money too are capable of repaying the loans.
What is a commercial mortgage?
A commercial mortgage is a property loan used to buy business premises. The mortgage operates in a similar way to a residential mortgage, in that the premises being purchased acts as the security in case you're unable to make repayments. If the mortgage repayments are not maintained the premises may be repossessed by the lender to recoup its losses.
In some cases, small business owners may be able to put up other assets of value, including personal property such as their home, as further security in order to increase the loan-to-value ratio of the maximum borrowing level. This can reduce the need for high liquidity or the burden of proving high levels of income in order to purchase the property your business requires.
Commercial mortgages tend to offer lower whole term repayment periods than residential mortgages, with 15 years a common term as opposed to the usual 25 or 35 with home loans.