There are many different types of mortgage available in the market. Despite the number of mortgages on offer being reduced significantly over the past year due to the economic recession and banking crisis, the two most popular types remain as the core offering.
The principal choice of interest offering when choosing a mortgage is between a fixed and a variable or tracker rate.
Variable rate mortgages are the oldest form available in the UK market. With a variable rate mortgage the interest rate charged on the loan balance changes at regular intervals to reflect more accurately the current cost of funds. So when interest rates are high, mortgage rates were high and vice versa.
The original variable rate mortgage used to fix a rate on its anniversary and then apply this to the balance outstanding on that day for the next year. The monthly repayment was fixed and the monthly instalment set for the next twelve months. This was a reasonable reflection of the rate, but since it charged interest on the whole balance at that time it did not take into account any reduction in capital made in the year.
As the market became more competitive, a wide range of variable rate mortgages were developed and launched into the market. These enabled more flexibility to be introduced into the market place and the frequency with which the rates were changed provided a more accurate tracking of changes in money costs. Tracker mortgages became very popular as interest rates were high since people expected to be able to benefit from a future fall in interest rates in the coming months and years. It is now possible to get a mortgage where the interest rate is set to track a wide variety of indices from the various bank base rates to LIBOR or Bank of England base rates.
Fixed rate mortgages, whilst common in the USA, are a relatively new phenomenon in the UK. Introduced through the late 80s and 90s they sought to introduce a greater element of certainty into mortgage costs by fixing a rate of interest to the mortgage loan for a period of time ranging from 2 years to 10 years. Whilst these brought certainty of cost to the budgeting process and insulated borrowers from any subsequent increases in interest rates, they also contained high exit or pre payment penalties for early settlement. Additionally, if interest rates dropped then no benefit came by way of reduced payments.
Choosing whether to fix or track can be tricky and comes down to an assessment of where you believe future interest rates might go. If you believe that they may increase, then you may want to consider fixing your loan payments for the next few years to insulate you against such increases. If you believe that interest rates may fall, then you could consider a tracker so as to benefit from the expected falls.
It is possible to have the best of both worlds by choosing part of the mortgage to be fixed and part tracking. This way, you are part protected or will receive a part benefit if rates change in the future. Equally, there are lower interest and fee penalties for early settling of a tracker mortgage. Although uncommon, they may offer a degree of flexibility if you are considering a move in the future. The fixed rate portion of the mortgage may be transferrable to your new home – but not always.
Without doubt the biggest drawback to fixed rate mortgages is the early termination penalties should you wish to end them early. Whilst most fixing periods are 2–5 years, you need to think carefully about whether this may be a factor affecting your next move.
At the end of the fixed period of interest you will have several options. These include dropping back onto the lender's standard variable rate charge, re-fixing for a further period or remortgaging with another lender. All these are still valid opportunities today despite the troubled times. Choice, however, may be limited especially if your current lender has ceased to offer new business. The key here is to start looking for alternatives early and not to wait until the end of the fixed period. If interest rates have moved significantly upwards since you took out your loan, be prepared for a large increase in monthly payments. Get estimates of what they may be so that you can prepare your household budget for the change. Above all, do not stop making payments for fear of getting an adverse credit history which can materially affect any future discussions over options and rates.