Although features and benefits vary, all mortgages involve repaying the capital sum (the money you borrowed) plus the interest on the amount you owe.
The two basic ways of repaying the loan are repayment mortgages and interest-only mortgages.
If you choose a repayment mortgage, you pay back the capital and the interest together.
If you choose an interest-only mortgage, you pay back the interest on a monthly basis and repay the capital at the end of the mortgage term.
With a repayment mortgage, each month you pay back some of the capital as well as interest on the sum still outstanding. In the early years you pay more interest than capital, but provided you keep up your payments, your mortgage is guaranteed to be paid off at the end of the loan term . This means that the repayment type of mortgage carries least risk.
With an interest-only mortgage, you pay interest to the lender, but you don’t repay any of the capital until the end of the term. Instead, you pay into a long-term savings plan, which should clear your mortgage debt when it matures. Possibly, if you are lucky, with some money to spare. There are three main types:
- an ISA mortgage where the savings plan is an Individual Savings Account. Like any ISA, this has tax advantages for most people and it is now the most common type of interest-only mortgage plan
- an endowment mortgage – basically a combination of life insurance and a savings policy. These used to be popular, but they have higher setting-up charges and less flexibility than ISA mortgages, and now have little to recommend them
- a pension-scheme mortgage – with these you use part of your pension fund to pay off the loan. This type is mainly suited to self-employed people and higher rate taxpayers.
Costs and risks
Over the whole lifetime of your mortgage, there probably won’t be much difference in cost between a repayment mortgage and an interest-only mortgage. But interest-only mortgages are slightly more risky than repayment ones, because there is no guarantee that the proceeds from the endowment, ISA or other policy will cover the whole sum you borrowed in the first place.
Many borrowers who took out endowment policies in the 1980s or 1990s to repay their interest-only mortgage are now finding that their endowment will not cover the full amount that they borrowed. If you are in this situation you should get urgent advice, and take action as soon as possible to try and catch up with the shortfall.
A lender’s basic mortgage will usually be at what’s called the standard variable rate of interest (or SVR) which goes up and down as bank interest rates change. But many lenders offer cheap rates or special deals which could mean that you have less to pay in the early years of your mortgage, for example:
Some lenders offer cashback deals where you get a percentage of the loan – say 5% – as a cheque to spend on your move or whatever you choose. But you may prefer not to go for this unless you really need the money, as the deal may tie you to the standard rate of interest for a number of years.
A ‘flexible’ mortgage gives you more freedom to repay at the speed you choose. You may be able to increase or decrease your monthly payments, building up credit you can draw on, or taking a payment holiday where you pay nothing for a few months. But you’re unlikely to get this flexibility and a very cheap interest rate.
Current account mortgages
A current account (or all-in-one) mortgage combines a flexible mortgage with a current account in one package. Money in your current (or savings) account can be set against the amount you owe on your mortgage or other borrowing, so that your interest payments are reduced.
These guarantee that the interest rate won’t change for a stated period – say, from two to five years. This means you don’t have to worry about increased payments in the first few years if interest rates go up. But if the lender’s standard rate falls below your fixed rate, you will lose out. You may be able to get a deal where you borrow part of your mortgage at the variable rate and part at a fixed rate – protecting you to some extent whether interest rates go up or down in the future.
With a discounted-rate mortgage, the interest rate may go up or down, but for a stated period it is always, for example, 1% lower than the standard rate.
With a tracker mortgage, the interest rate exactly follows the Bank of England base rate plus a specified percentage.
With a capped-rate mortgage, the interest rate is guaranteed not to go above a certain level during the capped period, often between three and five years.
Snags to watch out for
A cheap rate or a flexible deal may have strings attached, so ask your adviser or check the small print in advertisements. For example, the lender may require you to take out your house insurance or mortgage protection insurance through them. Or there may be a big redemption penalty (which could, for example, wipe out all the saving you made on a special deal) if you repay your loan early or switch to a better deal in the early years of your mortgage.
Many mortgages are described as CAT standard (CAT is short for Charges, Access and Terms). Non-CAT mortgages are not necessarily worse, but the Government CAT standard should mean a reasonable-value mortgage with no hidden charges or terms.
Where can I get advice about what would be best for me?
The decisions you make about your mortgage are very important, so you may need one-to-one help. Shelter Cymru cannot give financial advice. A financial adviser or mortgage broker can help you to understand all of the different repayment options. Always check the Financial Services Register to be sure that any financial adviser or broker that you use is authorized by the Financial Conduct Authority.