FOOL'S EYE VIEW
Five-Minute Guide To Mortgages

By Alison Hunt (TMFAlly)
April 12, 2005

Mortgages are essentially loans that you can take out to buy a home. You usually need at least a 5% deposit, and you pay back the other 95%, usually over a 25-year term. Once you've paid off the mortgage, the house is yours.

If you're thinking about buying a house, you'll soon be facing this bewildering world of mortgages. There are actually over 8,000 mortgage products currently on the market, so it's not surprising that choosing the one that's right for you can be scary. Especially as this is probably the biggest loan you've ever taken out!

Things can be just as confusing for those looking to re-mortgage too, with many choices to be made regarding fixed/variable rate, fees and the size of your deposit. Maybe this explains why one in three of us have never switched mortgage provider! But when you realize the savings you can make, you'll see why it's so worthwhile.

So if you're struggling through the mortgage maze, here's a quick explanation of the different types out there:

Mortgage Types

1. Repayment Mortgage

This is the safest way to purchase your home. You essentially pay off the loan in installments over a set term which, as we mentioned earlier, is usually 25 years. Each monthly payment whittles away both the interest and the loan amount. So, at the end of the term the house is definitely yours. This is the best choice for those who want a simple, low-risk way of purchasing their home.

2. Interest Only

An interest-only mortgage means that you're paying off only the interest on your loan each month. The loan itself is paid off by an alternative investment, such as an index tracker within an ISA wrapper that you're expected to set up. By investing a set amount each month, you should theoretically end up with enough money to pay off the bulk of the mortgage, and maybe a bit left over. However, remember this is theoretical – it all depends on how well your investments do.

This type of mortgage is really only suitable for those happy to monitor the progress of their investments – and remember this is likely to be a 25-year period. If you're not keen on the effort required and element of risk involved, choose a repayment mortgage.

3. Endowments

This is a type of interest-only mortgage that combines savings, investment and life insurance. The main problems with endowments are their inflexibility and very high charges (which negate much of any profit made) – hence we at the Fool believe you should steer well clear of them.

Whichever route you choose, you'll need to pay the interest that accrues on your loan – and there are a variety of different ways that lenders calculate this. Most deals on offer are for between one and five years, after which time you can re-mortgage for a better deal with another (or the same) provider.

Interest Rates

1. Standard Variable Rate (SVR) – this is linked to (usually between one and two percent above) the Bank of England Base Rate – and is often the most expensive choice. Currently, most SVRs are around 6.75%. You'll be able to get a better short-term deal, so try to avoid paying your lender's SVR.
   
   
2. Fixed Rate – the interest rate is fixed, usually for between one and five years. A good choice if you're on a budget, or believe interest rates are likely to increase in the future (two- and three-year deals are currently available for less than 5% plus fees of around £400). Watch out for any deals that charge redemption penalties beyond the term of the fixed-rate deal.
   
   
3. Discounted Variable Rates (DVR) – these are also linked to the Base Rate, but offer a percentage discount off the lender's SVR for a set period (after which you'll pay the SVR). A good deal as long as there are no redemption penalties, but remember, you must be prepared to move quickly when the discount period is up, or you'll negate the savings made (again two- and three-year deals are available for less than 5% plus fees of around £400).
   
   
4. Capped Rate – these variable rate mortgages provide a kind of 'happy medium' between fixed and variable rate mortgages, by 'capping' the maximum interest rate you pay, at a rate well below the lender's SVR, for between one and five years. So if your lender's SVR rises above your cap, you'll benefit. If they fall, you'll pay the same as everyone else. Therefore, capped deals are good for those on budgets, and if you believe rates will rise (current Best Buys start at just over 5% plus, you've guessed it, fees of around £400).
   
   
5. Trackers – these are variable rate mortgages that add a SET percentage onto the Base Rate (e.g. +0.2% - so if the Base Rate is 4.75%, you pay 4.95%. Your rate then tracks the Base Rate - should it rise/fall, yours will too. These are particularly good if you believe rates will fall, as you will benefit from the whole discount, not just some of it.
   
   
6. Offset /Current Account (CAM) Mortgages - These mortgages combine all of your savings, loans and mortgage together – meaning that your savings are used to 'offset' (and thus reduce) the interest payable your mortgage and loans. (CAMs also take into account the balance of your current account.) Although you no longer receive interest on your savings, you're effectively reducing your mortgage by the balance of your savings pot – and so all in all you're saving by paying less interest. You can find out how it works in this article. Offset and CAM mortgages are a brilliant concept, especially if you have a large rainy day fund set up, and/or you're a higher rate tax payer, as this money can be used to effectively reduce your mortgage (and as it doesn't earn any interest, it won't be taxed). However, check the rates carefully; they can often be less than competitive –it can make more sense to take out a flexible repayment mortgage and overpay.

Other Factors

And on top of all this, there are a few other factors that you should check when choosing your home loan.

Flexibility – the most important thing to ask – how is the interest calculated (is it daily?) and are you free to overpay/underpay? You can save a fortune by choosing a flexible mortgage and overpaying – and shave years off the time it takes until your home is all yours.

Cashback – this may seem like a great deal, to be offered some cash back when you've just forked out every penny you have. But lenders rarely give money away – so check the small print carefully!

Loan To Value ratio - the bigger the deposit you have, the better the deal you'll be offered (in most cases anyway).

Mortgage Indemnity Premium – find out more and how to avoid paying it here.

Life Insurance – watch out for lenders that insist on you taking out their life insurance – find a competitive policy in our Insurance Centre.

Fees – Best Buy mortgage rates often conceal hidden 'stingers' in the form of high arrangement fees – a bit sneaky as they give with one hand and take with the other. Check the fees payable on your deal carefully; you may find it easier to compare by finding out the monthly payments for each deal.

Finally, if you're re-mortgaging, you can potentially save some time and money by giving your lender a ring to see if they can offer/match a better deal?

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