FOOL'S EYE VIEW
How To Choose A Mortgage

By Cliff D'Arcy
June 5, 2003

Fans of the Fool will know that we're not keen on borrowing. That's because many lending products, especially credit cards, can charge exceedingly high rates of interest. You'd have to be mad to pay interest at anything up to 30% APR when the base rate is a mere 3.75%.

However, we do feel it's a good idea to use a mortgage to buy a home (if you can't afford to buy one outright). That's because surveys show that, in the long run, it's cheaper to buy than rent. However, some mortgages will suit your needs better than others, so how do you decide which one's best for you? Read on, dear Fool!

The basics

A mortgage is a loan secured on your home, usually arranged for a term of 25 years. If all goes well, you'll make all 300 monthly repayments and end up owning your home. Marvellous!

If something prevents you from meeting your payments, your lender can repossess your home and sell it to pay off your debt. Hence the ominous warning, "Your home is at risk if you do not keep up repayments on a mortgage or other loan secured on it."

To find out what you want from a mortgage, you need answers to just four questions (everything else is pretty much padding):

1. How much can you borrow?
2. How much can you really afford?
3. How do you want to repay your debt?
4. How do you want interest to be charged?

The above links give answers to the first two questions; this article focuses on questions 3 and 4.

How do you want to repay your debt (safety or shares)?

You need to determine your attitude to risk in order to make this decision. If you're frightened silly by the thought that shares can go up or down, you may well be better with a repayment mortgage.

With a repayment mortgage, part of your monthly repayment meets the interest charge and the remainder goes towards paying off your debt. In the early years, your repayments mostly go towards paying interest; in the later years, more and more capital is repaid as the interest charge shrinks. Your final payment extinguishes your debt and you are mortgage-free - guaranteed.

Alternatively, you can opt for an interest-only mortgage, which means that your monthly repayments only repay the interest and do not chip away at your debt. In order to pay off your loan, you need to arrange a "repayment vehicle" - in plain English, a savings plan. Two common repayment vehicles are tax-free share ISAs and personal pensions. The idea is that your monthly savings build up until they are sufficiently large to pay off your debt when (or before) your 25 years is up.

Until the 1990s, many borrowers took out endowment policies alongside their mortgages, but these have fallen out of favour in a big way. Of course, share ISAs, personal pensions and mortgage endowments typically invest heavily in shares, which have proved to be the best long-term investment. However, if you are nervous about the unpredictability of investing, you could split your loan into repayment and interest-only elements.

How do you want interest to be charged?

Lenders charge mortgage interest in six basic ways:

1. Standard variable rates (SVRs)

The normal bog-standard rate paid by borrowers who aren't on a special deal. Although some lenders offer competitive rates (as low as 4.3%), SVRs can be as high as 5.85% - ouch! Lenders love customers who can't be bothered to switch from their SVRs to a better deal, as they make a packet from our laziness. Avoid paying the SVR unless you absolutely can't find a better deal elsewhere.

2. Discounted variable rates (DVRs)

These offer a discount off SVRs and, therefore, lower payments. Discounts may apply for as little as three months or up to five years or more. The biggest discounts usually come with strings attached in the form of "redemption penalties". These are lock-in penalties that penalise you if you decide to get out of your special deal early. Some deals even include penalties that extend beyond the discount period; these penalties are known as "redemption overhangs" and are worth avoiding.

According to Moneyfacts, you can pay as little as 3.35% for a two-year discount and 3.79% for a five-year deal (remember that these rates will rise and fall with the lender's SVR).

I like DVRs because you're guaranteed to make a saving on the SVR, plus they go down if the lender reduces its SVR (and vice versa). But, if you need the security of knowing exactly what your payments will be for years ahead, DVRs aren't for you.

3. Fixed rates

They do what it says on the tin: whatever happens to base rate and the lender's SVR, your rate is fixed for a pre-determined period. Most fixes are for between two and five years, but can run for the full 25 years. As with most DVRs, fixed-rate mortgages always carry redemption penalties, so watch out for very low initial rates that trap you into paying an unattractive SVR for years afterwards.

Current fixed rates with no redemption overhang range from 3.34% for two years to 3.95% for five years.

Many first-time buyers choose fixed rates to guarantee their payments in the early years, when they are adjusting to life with a mortgage.

4. Capped rates

These are variable-rate mortgages with a twist. They include a cap that limits the maximum rate you pay, usually at a rate well below the lender's SVR. As with DVRs and fixed rates, most capped rates last for between two and five years.

So, if your lender's SVR falls below the level of your cap, you pay the SVR. If it doesn't, you simply pay the cap. Caps are useful if you think interest rates will fall during the life of your deal; current Best Buy capped-rate deals vary from 3.99% for two years to 4.49% for five years.

5. Trackers

Easy as pie: you pay the Bank of England base rate plus a predetermined premium. For example, with a base+0.75% mortgage, you would pay 3.75+0.75 = 4.5% now. So, when the base rate is cut by 0.25%, the entire 0.25% cut is passed on to you. With SVRs, there is no guarantee you'll get the full effect of a rate cut.

If you think the base rate will fall or stay low, trackers offer an attractive alternative to SVRs, but rates may not be as low as the best DVR or fixed-rate deals.

6. Flexible, offset and current account mortgages

These are the coolest and most adaptable mortgages around - you can overpay, underpay, take payment holidays and use your credit balances to reduce your interest bill. Currently, these represent the pinnacle of mortgage evolution and could save you thousands of pounds over the life of your mortgage. Visit our 21st Century Mortgage Centre to see how.

Be warned that interest rates for these three types of mortgage can be higher than the best fixed- or discounted-rate deals, so tread carefully.

More: Find a cheaper mortgage in our Mortgage Centre | The Fool's Mortgage message board

Thanks to Moneyfacts for supplying the data for this article.