Interest Rate Structure - Mortgage Guide

The first question that most people ask when considering a new mortgage is 'What type of interest rate structure is best for me? - Should I take a fixed rate, a capped rate, a discounted rate, a stepped rate, a standard variable rate or a cashback deal?' Indeed this all important question is one that needs very careful consideration. So let's look at each of these options in turn and attempt to simplify the choices available.

Fixed Rates

Fixed rate mortgages are available on a variety of terms and for most periods. At one end of the scale there are some very short term deals fixed for say 6 months, and at the other end of the scale there are offers that will fix the rate for the entire term of the mortgage.

So should you opt for a fixed rate and if so what are the catches to watch out for? The decision you make here will normally depend on two factors. The first is what you feel will happen to interest rates over the coming months/years and secondly your approach to risk. Let me explain in more detail - If you feel that interest rates are likely to fall then it is unlikely that you will want to tie yourself in to a fixed rate for any period, particularly if you feel that the normal variable rate is likely to fall below the fixed rate. You will probably feel more inclined to take a discounted rate in these circumstances as you can then benefit from any fall in interest rates with a reduction in your mortgage repayments.

The second consideration that will influence your decision is your attitude to risk. If you like to budget with certainty then you will probably want to fix your repayments for a reasonable length of time. Equally important is the amount of leeway you have with your budget and whether you can afford to meet any increase in repayments. If you are a first time buyer and have borrowed to your maximum limit then it is probably sensible to fix your repayments at a level which you can comfortably afford. If there is little 'slack' in your budget then you must consider 'can I really afford to take a chance on interest rates rising?'

So, if you decide to opt for a fixed rate what are the catches and what points should you particularly watch out for? First let's look at the disadvantages of taking a fixed rate. Clearly the most obvious disadvantage is if interest rates fall - in this case you could find yourself paying more than you would have had to with a variable or discounted rate. If you have opted for a long term fixed rate then this decision could cost you dearly over the period of the fixed rate. You will also find that, with most fixed rates, you will be charged a penalty (called a redemption penalty) if you wish to change your mortgage or pay it off completely or in part in the first few years. With most fixed rate mortgages this penalty will certainly last for the term of the fixed rate and it is quite common for these penalties to extend beyond the fixed rate term, thereby tying you into that mortgage for a number of years after the fixed rate has finished. These redemption penalties are usually imposed at a level that would make it uneconomic to change the mortgage or transfer to another lender whilst the penalty is in place.

There many lenders who offer fixed rates without redemption penalties or with penalties that only last during the fixed rate period. These products are certainly worth considering although you will usually find that, as a result of this, the rate offered is not the most competitive in the market. However, you do then have additional alternatives if interest rates work against you and you could be free to negotiate an alternative rate with the lender or, if the worst comes to the worst, move to a different lender.

Capped Rates

A capped rate will give you the best of both worlds between a fixed rate and a variable rate. The cap is basically a ceiling on the interest rate above which it will not rise. On the other hand, if the normal variable rate falls below the capped rate then the variable rate will be charged. So, you have a guaranteed maximum rate with the benefit of a reduction in interest rate if this happens - sounds too good to be true? Well there are some catches - first you will usually find that the cap is set at a higher rate than the best fixed rates for a similar period. So, for example, if a capped rate is offered for 5 years capped at 8% you may find the best five year fixed rate is being offered at 7%. Secondly, you also need to watch out for redemption penalties as with fixed rates. The third point to watch out for is that sometimes these products are sold as 'cap and collar' products. This basically means that, as well as a ceiling on the interest rate above which it cannot rise there is also a collar on the rate which is a level below which the rate cannot fall. For example a product may be sold with a cap of 8% and a collar of 5% for 5 years. This means that within that 5 year period the interest rate is guaranteed not to rise above 8% but it will also not fall below 5% within that time either. This means that if the normal variable rate falls below the collared rate you will be paying 'over the odds'.

Discounted Rates

Discounted rates are usually linked to the normal variable mortgage rate but with a discount for a set period of time. This means that the interest rate you are paying will fluctuate up and down in line with base rates but you will be guaranteed to receive the discount for a set period of time.

Most of the discounted rates on offer at the present time will give the discount over the first one, two three, four or five years. The total amount of discount on offer tends to work out approximately the same over the period of the discount so, in broad terms, you are making a choice between a large discount for a short period of time, a small discount over a long period of time or something in between. For example one product may offer a 3% discount over 2 years and another a 2% discount over 3 years. The total discount you receive in either case is 6% so the choice you are faced with is what period to take the discount over. There are a few products that will offer the discount over a shorter period than one year and a few that will offer the discount spread over a longer period. There are even some lenders who will guarantee you a discount for the life of the mortgage and these products are certainly worth considering if you are not looking for a substantial reduction in your repayments over the short term.

So, what are the disadvantages of discounted rates and what are the catches to watch out for? Broadly speaking, you have the same catches to watch for as for fixed rates. Look out for the early redemption penalties imposed on you by the lender. In particular watch out for products that have redemption penalties which extend beyond the period of the discount. If this applies to the deal you have taken then you will be tied to the lenders normal variable rate at the end of the discounted period and you will be denied the opportunity to rearrange your mortgage or negotiate better terms with your current lender without paying the redemption penalty. Also consider what the lenders normal variable rate is and has been in the past. Does the lender have a track record of charging a competitive rate or does their normal variable rate tend to be on the high side.

The other advantages and disadvantages depend on what happens to interest rates over the period of the discount - if interest rates fall then you will take advantage of any reduction and see your monthly repayments fall. On the other hand if rates rise then your repayments will increase to reflect the change.

In summary, therefore, you should probably avoid discounted rates if you are on a very tight budget unless you feel absolutely certain that interest rates will fall and remain low for the foreseeable future. However, if you are budgeting with a reasonable amount of leeway and you feel it is likely that rates will fall then a discounted rate could be just the thing for you and may save you a considerable amount of money over the early years of the mortgage.

Stepped Rates

A stepped rate may be either fixed or discounted. The term 'stepped' simply means that the rate will change in steps at certain fixed intervals. For example a stepped fixed rate may offer a rate of 3% in year 1, 4% in year two and 6% in year three - in this example therefore you have a fixed rate for three years which increases in these three stages. An alternative to this may be stepped fixed rate where the interest rate decreases over the term of the fix. For example the rate may be 7% in year one, 5% in year 2 and 4% in year three. In this case the interest rate is again fixed for three years but at the three different steps.

A stepped discounted rate will work in a similar fashion to the above but instead of the interest rate itself being fixed, the amount of the discount will be set. Again the size of the discount may step up or down over the period according to how the lender has chosen to structure the product. For example you may be offered a discount of 3% in year 1, 2% in year 2 and 1% in year three. Alternatively the step may be set in reverse with 1% off in year one, 2% in year two and 3% in year 3.
Stepped rates have the same disadvantages and advantages of the fixed and discounted rate products and are simply a variation on the same theme. Again you should watch out for early redemption penalties.

The stepped rate market is smaller than the conventional discounted or fixed rate market and fewer products are launched in this format. However, it is one that you should be aware of and one that will suit some people. Obviously individual circumstances and requirements vary considerably and these products will appeal to some people, particularly if they can see the stepped rate fitting in with planned changes in income.

Standard Variable Rates

The mortgage market has become increasingly competitive over the last few years and you could be forgiven for thinking that straight variable rate mortgages no longer existed or were not worth considering. However, over the last couple of years standard variable rate mortgage products have started to make a come-back particularly with the direct lending operations. Rather than simply being rate driven these products can be attractive for a number of other reasons. We have already discussed early redemption penalties in the previous sections. These penalties can be extremely onerous and will normally be applied even on partial redemption. If you envisage that you may be in a position to pay off lump sums then the penalties that you may incur will detract from the value of the fixed or discounted rate. In addition many of these direct lenders are able to offer extremely competitive variable rates which will undercut the more traditional lenders. If this is maintained over a period of years then you could find yourself benefiting from a very competitive rate without all the restrictions of an actual discounted rate.

In addition to this benefit you will also find that many of the lenders who offer these products will also charge interest daily rather than annually which will give a great interest saving on a repayment mortgage over the entire period of the mortgage. These products are explained in more detail under section five which deals with flexible 'current account' mortgages.

Cashback Deals

There are a plethora of cashback deals currently available and these range from products that offer a few hundred pounds back on completion, to schemes which will offer you a percentage of the mortgage amount. Cashback mortgages are ideal if you are happy to sit with a normal variable rate but wish to raise some extra capital without increasing the mortgage debt. Many of the deals available will offer a percentage of the mortgage amount as a cash sum on the basis that the interest rate charged by the lender will be the normal variable rate with no discounts. All that the lenders are doing here is to give the offer of cash up front as an alternative to a discounted rate.

An alternative to the very large cashback offers are products that offer a discounted or fixed rate with a smaller cashback. This may be a few hundred pounds and these cashback offers are really designed to cover the costs of arranging the mortgage. In addition some lenders will refund costs such as the arrangement fee and valuation fee once the mortgage completes.

Another use for cashback products that is sometimes overlooked is to fund part of the deposit that the lender will usually require you to put down from your own resources. For example, if you are buying a property for the first time you may be considering a 100% mortgage. There are a number of lenders that will offer the facility of 100% mortgages but in general terms you will not find the products to be the most attractive available in the market as a whole. However, if you can find a lender who will offer you a 95% mortgage with a 5% cashback then you may find the interest rate on offer to be more attractive. You will still need to fund the deposit of 5% from your own resources in the short term but then once you have completed your purchase the lender will give you the 5% back. This approach is worthy of consideration if you are considering a 100% mortgage.

Summary

The following summary should help you to understand the pro's and con's of each type of product:

PRODUCT TYPE	ADVANTAGES	DISADVANTAGES
Fixed Rates	Ability to budget with certainty. Could save money over the long term, particularly if interest rates rise. It may be possible to fix at a lower rate than the usual variable rate.	No benefit from reductions in rates. Could cost money if interest rates fall. The lender may impose early redemption penalties The lender may insist on arranging some insurance policies. An arrangement fee may be charged.
Capped Rates	Ability to budget with certainty. Benefit of reduction in interest rates if they fall below the cap. Could save money over the long term if interest rates rise.	The rate may also be collared at a level below which it cannot fall. The lender may impose early redemption penalties. The lender may insist on arranging some insurance policies. An arrangement fee may be charged.
Discounted Rates	A saving can be made over the period of the discount. Benefit is gained if interest rates fall	The monthly repayments will increase if interest rates rise. The lender may impose early redemption penalties. The lender may insist on arranging some insurance policies. An arrangement fee may be charged.
Stepped Rates	As with fixed and discounted rates plus; Ability to tailor the rate to take account of anticipated changes in circumstances i.e. increases in salary	As with fixed and discounted rates depending on the option chosen.
Standard Variable Rates	Benefit from reductions in interest rates. Flexibility - ability to pay off lump sums without penalty. Many products will feature a drawdown facility to give access to further borrowing. Many lenders who market standard variable rates heavily will charge a very competitive rate. Many of these lenders will charge interest daily rather than annually giving instant benefit from debt reduction.	Will cost more if interest rates increase. No benefit from discounts or cashbacks. No ability to budget with certainty
Cashback Products	Ability to raise additional funds without increasing the mortgage debt. Cashback can be used as part of deposit required for house purchase. Cashback can be used to cover all or some of the fees.	Rate may be variable so repayments will increase if rates rise Interest rate may be loaded. Lender may impose early redemption penalties. Lender may insist on arranging some insurance policies. An arrangement fee may be charged.

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Contents

mortgage guide

2. Choosing the most suitable interest rate structure