When you are looking to take out a mortgage for the first time, you will soon discover that there are a number of different types of mortgages to choose from and it is important to understand the differences, so you can identify which option is the best one for your circumstances.
What is a fixed rate mortgage?
A fixed rate mortgage is a product type that remains at the same interest rate throughout the agreed period. This compares to a variable rate mortgage, which is one that can fluctuate. For example, a tracker mortgage interest rate increases or decreases in line with the Bank of England base rate.
One of the key advantages of having a fixed rate mortgage is that there will be no unexpected increases and it is therefore easier to plan your finances and make sure that you can afford the monthly payments.
Fixed vs variable rate
With a variable tracker mortgage, if the Bank of England base rate was to increase by 1%, the mortgage interest rate would also increase by 1%, which could take the payment above your monthly affordability. For this reason, many mortgage applicants prefer the security of a fixed rate mortgage so they know exactly what they need to pay each month for the remainder of the term.
People who need to have more flexibility with selling properties in the short-term, for example, if they move around a lot through their job or simply do not want the commitment of staying in the same property for a set period, are often better opting for a variable rate. This is because there are rarely any early repayment charges attached to variable rate mortgage products.
What are the different types of fixed rate mortgage?
The different types of fixed rate mortgages are defined by the length of time they are fixed for, with the most common product term options being: 2-year, 3-year, 5-year and 10-year.
What happens when your fixed rate mortgage ends?
With the 2-year fixed rate, you have an initial period of two years where the interest stays the same and at the end of the initial period, it will usually revert to a standard variable rate. There may be the option to switch to a new mortgage with a fixed rate again if you meet the most suitable lender’s lending criteria. When the fixed rate mortgage ends, moving to the standard variable mortgage can involve a significant increase in the amount of the monthly payment, so this is when most people will find a better mortgage deal to switch to.
Pros and cons of fixed rate mortgages
There are several pros and cons of taking out a mortgage on a fixed rate. The main factor to consider is whether your circumstances are likely to change within the near future. When you agree to a fixed rate mortgage, there will usually be a significant penalty if you end the mortgage within the fixed rate period (known as an early repayment charge or ERC).
This penalty will often be that you pay a percentage of the overall mortgage loan as a penalty, if for any reason you redeem the mortgage early. For example, you might decide to sell your property for a number of reasons. Circumstances can easily change such as a relationship breakup, a change of job or being made redundant, which might leave you with no choice but to sell your property.
With a variable rate mortgage, you may not need to pay an early repayment charge but you are likely to pay a much higher amount in interest payments.
Which is better, shorter or longer fixed rate terms?
If you were to take out a 10-year fixed rate mortgage, you would be required to pay an early repayment fee if you sold the property within those ten years and redeemed the mortgage. This is why more people opt for the shorter length of period, such as 2-year or 3-year, so there is less risk of having to pay the penalty fee.
When people opt for a 10-year fixed rate, it will usually be at a time where the Bank of England base rate is low and therefore locking into a low fixed rate for a long time is beneficial. They will be fairly confident that they will still want to keep the same property in ten years’ time or they will have the option to move their mortgage to a new property.
There is a risk associated with taking out the longer 5-year and 10-year fixed rate mortgages that you will miss out on significant savings if the Bank of England base rate reduces and better mortgage rates become available, but you are tied into your long-term fixed period.
To get the cheapest interest rate, opting for a 2-year fixed rate will be significantly less than a 10-year fixed rate. When the Bank of England base rate is particularly low, you will find that there are less long-term fixed rate deals available, as mortgage lenders see this as a risk of losing money if the rates go up again.
How do the early repayment charges work?
In the example of a 5-year fixed rate, the ERC will often start off at 5% of the outstanding loan balance and with each year that follows, it will reduce by a further 1%. Therefore, ending the mortgage after four years will incur a considerably lower penalty charge than ending it after one year.
Mortgage lenders do this so that they do not lose money, as most of the work that they do is at the beginning of the mortgage, where the administration activity such as processing and completing checks etc. happens. The longer that the mortgage holder has the mortgage, the more money the lender makes from the interest, so they want people to keep their mortgage for at least a couple of years to make it profitable enough for them.
Can you make overpayments?
Another benefit of choosing a fixed rate mortgage is that you are often able to overpay on your mortgage, which will allow you to save money over the length of the mortgage term, as you will reduce the amount of outstanding interest. You might not be in a position to overpay at the beginning of your mortgage but having the option to do so later, is a good flexibility to have. Lenders will typically allow overpayments of up to 10% of the amount outstanding per annum without any early repayment charge.
Is a fixed rate mortgage right for you?
Whether a fixed rate mortgage is the right option depends entirely on your circumstances and what your future plans hold. People who know that they definitely like the property and the area it is located in and are confident that their circumstances (like job security and relationship status) won’t change, are more likely to benefit from a fixed rate mortgage.
The fixed rate mortgage deals are often considerably cheaper in terms of interest rates than variable, so by sacrificing flexibility, you are benefitting in savings. However, if there is a chance that your situation will change, maybe your job security is not very high, or you are in a relationship that is not very stable, then a fixed rate mortgage could end up causing you a lot of inconvenience.
In the event that you were to lose your job and would be unable to make your mortgage payments, you might not have any other choice but to sell your house, in which case you would need to pay any applicable early repayment charge.
To give you an idea of how much this could cost, on an outstanding mortgage loan of £200,000 a 5% ERC would be £10,000, so this is potentially a very large fee and a big risk to take.
In the scenario where you took out a joint mortgage and then the relationship ended, there would be a number of possible outcomes. One person on the mortgage could re-mortgage into their sole name and pay half of any equity to the other person, or the house would be sold, and any equity split. In either case, the early repayment charge would need to be paid, which could cost the two people £5,000 each for the ERC when it is taken out of the calculations.
So, there are many different scenarios where a fixed rate mortgage could be the wrong decision but by choosing a shorter fixed rate length, you reduce the risk and reduce the percentage that you would get charged.
If there is a possibility that you might want to move to another property in the near future, e.g. you are planning to start a family and will need more space, then you should make sure that you have a portable mortgage. This means that if you want to move house during your fixed rate period, you are able to move the mortgage over to the new property without incurring any early repayment charge, although the mortgage affordability would have to be recalculated.
The other factor to consider is the existing mortgage market and currently (at the start of 2021), due to the COVID-19 health pandemic, interest rates are at a comparably low level to one or two years ago for those who have over 20% equity/deposit. This means that being fixed to a low rate for a longer period of time could be very financially beneficial to people who are happy to get tied in. Whereas, the opposite applies for those with less than a 20% deposit/equity. Due to the significant risks associated with lending during the pandemic, the high risk mortgage applications at the higher loan-to-value brackets are currently seeing interest rates increase.
Boon Brokers offers impartial mortgage advice to enable you to make an informed decision regarding which type of mortgage to take out and if you opt for a fixed rate, we can help you to choose the length of initial period that is most suitable for your circumstances and future plans. The best part is that we do not charge any client fees for our advice or arrangement mortgage services. We are paid a commission directly by the lender on completion of the transaction.
Call us today to discuss your mortgage requirements and we will be happy to help.