LENDING ZONE
It’s worth going back to basics to work out what mortgage is best for you
Financial worries or just looking for better value for money? Consumer champion Fergus Muirhead can help
I GET so many questions from you about mortgages that I thought I would answer a few of them this week by taking a look at some of the different types of loans out there, and how you can decide which one is right for you. Some of this might seem very basic but sometimes it is the basics that trip us up, and it’s worth going back and looking at how these things work from time to time. Let’s start with the difference between an “interest-only” loan and a “repayment” loan. The vast majority of new loans are arranged on a repayment basis these days, and with good reason. If you have an interest-only loan, all you will pay to your lender is interest every month, which means that at the end of the mortgage term, usually (but not necessarily) 25 years, you will still owe your lender all of the money that you initially borrowed. While this can lead to much lower monthly payments, it can also lead to real difficulties, unless you have another way of paying back the money you borrowed, and lenders will only agree to these loans now where borrowers have a specific plan arranged to repay the capital.
Most loans these days are set up on a repayment basis, where one payment to the lender every month includes both interest and capital.
In the early years, most of your monthly repayment will go towards paying interest and so the outstanding loan will reduce slowly.
As the debt reduces and less interest is charged every month, the speed at which the debt is repaid will increase and, all other things being equal, the loan will be completely repaid at the end of the agreed term. A repayment loan is probably a better idea for most borrowers these days, unless you have some guaranteed way of coming into enough money to repay your loan at the end of its term.
You also have to decide whether a fixed rate works for you. A fixed rate mortgage does what is says on the tin.
It fixes that payments you will make to your lender for an initial period of time when the loan starts, usually two, three or five years, although it is possible to get a fixed rate that lasts for 10 years, or perhaps even for the whole term of the mortgage.
The benefit of a fixed rate is that it allows you to budget properly, safe in the knowledge that whatever happens to Bank of England base rates, your
loan repayments won’t increase for the entire fixed rate period.
This can be really useful if money is tight, or if you don’t like the uncertainty of payments increasing suddenly and without warning.
If your budget is pretty flexible and you have plenty of money left at the end of the month, then you might be prepared to sacrifice that security for the “gamble” that interest rates fall and variable rate monthly payments get even cheaper.
Unlikely in today’s low interest market but as interest rates rise over the next couple of years, this decision will become more important. Until recently, the best fixed rate loan would be significantly more expensive than the best variable rate but the gap has narrowed considerably in the last few years, making fixed rate loans much more attractive, although the starting point for most fixed rate products is still higher than a variable rate.
So the upside of a fixed rate is that you can budget more easily, you’ll know exactly what you will pay every month and you won’t see these payments increase if the Bank of England increases base rates.
The disadvantages are that you won’t see your payments decrease if base rates do down, and you will probably have to pay a penalty if you need to get out of the mortgage before the end of the fixed rate period.
Some fixed rates will let you pay off a small amount of the capital without incurring this penalty, so if you think you are likely to want to make capital repayments, perhaps from bonus or dividends, during the fixed rate period, check the rules before you agree on a loan.
Make sure that you set any fixed rate period to suit your longer term plans. If you think that your job will mean a move in three years then you probably won’t want to have a five year fixed rate for example.