FOOL SCHOOL
Homeowning: Which Type Of Interest Rate?

May 3, 2002

Interest rates are probably the most important part about buying a house. After all, your aim is borrow the money you need for the least possible cost, so you need to assess which type of interest rate is best for your particular circumstances.

Standard Variable Rate

This is the general rate of interest that lenders use and it's usually the most expensive option for the borrower. The standard variable rate is linked to the Bank of England's base rate and moves up and down in line with it, and a typical rate at the moment is about 1% to 2% higher than the base rate. So whenever the lovely Sir Trevor McDonut announces on the News that the Bank of England has raised or cut interest rates by a quarter of a percentage point, you'll know your mortgage rate is probably about to go up or down by a similar amount.

If you're on this sort of standard rate, you'll probably notice that lenders like to introduce any increase with effect immediately and to delay any cuts by a month or two. It's a nice little earner, see? At any rate, it's never going to be the cheapest deal on the market so if you find yourself landed with it, be aware that you're effectively subsidising all the other borrowers who are taking advantage of any cut-price special offers!

Fixed Rates

This is exactly what it says. The rate of interest is fixed for a certain length of time -- usually 1-5 years -- so you'll know exactly how much you'll need to find each month to pay the mortgage. The fixed rate is great for people who are a little stretched financially and need to know where they stand from pay cheque to pay cheque. They're also good value if interest rates look set to rise in the early years of a mortgage, although bear in mind that the mortgage providers are likely to be one step ahead of you and adjust their fixed rates accordingly. However, a fixed rate also means you could be lumbered with paying more than everyone else if general interest rates fall below the figure you've set yours at. But that's the risk you take in exchange for having certainty about how much you will pay each month.

Discount Rates

This is simply a percentage discount off the lender's variable rate. So your monthly payments will move up and down in accordance with the lender's normal rate but you'll be paying at a reduced rate over the relevant time period. These are quite good for first-time buyers as a discounted mortgage can give you a couple of years of breathing space. A one or two per cent discount is especially good if there's no lock-in period afterwards because you can simply re-mortgage with another lender when the discount period comes to an end. Unfortunately, you'll often find you're locked in for another couple of years on the variable rate -- so you won't be able to get out of this sort of deal unless you're prepared to pay huge redemption penalties.

Discount mortgages offer good value for money - but only if there is no lock-in period once the discount has come to an end.

Capped Rates

These ensure that there is a ceiling to the interest rate you will pay over a given period of time. If your lender's variable rate climbs higher than the capped rate you will benefit. But if it falls below the capped rate you'll just be paying what everyone else is paying.

Capped rates tie you in to the mortgage for a set period of time -- usually between 1 and 5 years -- although we've recently seen the introduction of the first mortgage to be capped for 25 years. These are quite common in the United States but it's the first time the concept of applying a capped rate for the full term of the mortgage has been introduced to the UK. It was only on special offer for a short period of time but, no doubt, someone will revive it again at some point.

Capped rates give you part of the advantages of fixed rates and of variable rates. Again, you'll have to give something back for this. For example, the capped rate is likely to be higher than any fixed rate you can get. Like fixed rates, they make good sense for those on tight budgets who need to ensure that their monthly payments don't rise too far.

How Is The Interest Charged?

Regardless of the type of interest rate you go for, one vital question to ask is how frequently interest is calculated. If you opt for a mortgage on which the interest is calculated daily (sometimes referred to as an Australian mortgage) you'll pay much less interest over time because every payment immediately reduces the amount you owe. Current account and flexible mortgages will charge interest daily. Where the interest is calculated monthly, you might end up waiting a whole month after making a payment before the interest is recalculated -- so you end up paying interest on money you don't actually owe any more!

But some lenders are sneakier still. They calculate the interest payable on the amount due at the start of the year and this can add several pounds to the typical monthly mortgage payment. It also means that if you make an additional payment to reduce your mortgage it could be up to a year before this reduces the amount of interest you are charged.

Comparing Mortgages

The easiest way to compare mortgages is to look at the amount you need to pay each month. Just looking at the headline interest rate can be misleading, as we have seen that different companies charge interest in different ways. Remember that if you are going for any short-term special offer that you need to consider your monthly payment once the promotion period is over. Ideally, you want a competitive rate then as well and no redemption penalties so that it is cheaper to move your mortgage elsewhere if there are more attractive mortgages available (which there probably will be).

By law mortgage providers have to provide an Annual Percentage Rate (APR) for their products. It illustrates the true underlying interest rate, including all the charges, over the entire term of the loan. This means it adjusts for things such as annually charged interest. Comparing the APR of one loan against another can also help you get a better feel for which is the most competitive.