Methods Of Paying Interest

Now you've seen the different methods of repaying a loan, it is time to look at how interest is charged. Once again, you have three basic choices: variable rate, fixed rate and capped rate.

Variable - As the name suggests, during the course of the loan the interest rate can go up or down.

Fixed - The fixed rate mortgage provides guaranteed monthly payments for a predetermined period.

Capped - Maximum monthly payments are guaranteeed for a period.

And watch out for redemption penalties.

VARIABLE

As the name suggests, during the course of the loan the interest rate can go up or down. There may be spells of several months when the interest rate remains constant, or the rate can change many times over a course of months.

The interest rate charged by the mortgage lender is largely determined by the Bank Base Rate, so when the Bank of England announces a Base Rate change, variable mortgage rates usually follow the movement (up or down).

Often, many of the lenders charge the same or very similar standard mortgage rates, but be wary of any lender that has a standard variable rate (SVR) that is considerably higher than the rest.

Lenders often offer incentives to borrowers to encourage them to take a variable rate mortgage.

1- Discounts

A discount rate mortgage guarantees that you will pay a set amount below a lender's standard variable rate for a specified period of time. Whilst the standard variable rate goes up and down, the discount will remain fixed.

You can get a discount mortgage lasting from as small a period as six months up to about five years. In general, the shorter the period of the discount, the higher the discounted rate will be. For example, if you have a two year discount, you may get a discount of 1% of the standard variable rate, but a one year discount could be 2%.

Discounted mortgages are recommended for those where it is important to keep their initial payments as low as possible. Perhaps because it is their first mortgage, their income isn't so high and they want to have some spare cash to spend. For example, on furnishing their home or on car repayments. The discount period can help you achieve this.

You should find out whether there will be redemption penalties for changing your mortgage after your discounted period has ended. If there isn't, it may benefit you to wait until the end of the discount period then move to another discounted mortgage, hopefully with no overhanging redemption penalties. After that one, you could move again. In fact, assuming the mortgage market stays the same, you could benefit from discounted mortgage for your whole mortgage term.

You should note that if you don't remortgage, and you do nothing after the pre-determined discount period, you will go the standard variable rate.

So why do lenders offer these discounts, when the payable rate is lower sometimes than the bank of England base rate, or more importantly, lower than the savings rates that they offer? Well, quite simply, it's a marketing ploy. It's no different to any other sales promotion offered by any retailer. They are allowing you to buy the same product but at a discounted price, so that you become their customer.

2- Cashbacks

Lenders may offer a sum of money towards the cost of legal fees or survey charges.

3- Subsidies for fees

Lenders may offer a sum of money towards the cost of legal fees or survey charges

4- Mixtures

Lenders sometimes offers combination of the incentives listed above

Base Rate trackers

Lenders do not always pass on every cut in the Bank of England Base Rate, although they will almost always pass on Bank Base Rate rises! Lenders justify this behaviour by pointing out that they have responsibilities to both borrowers and savers. This is true, but it is very likely that they are lending more money than they have saved in their accounts, so its the lenders who benefit most from this policy.
If you want to make sure that your mortgage absolutely follows the behaviour of the Bank Base Rate, then you can take out a tracker mortgage, which will always follow the Bank Base Rate.

An advantage of the tracker mortgage is that the difference between the variable rate and the base rate is usually a lot smaller than the margin between the ordinary variable rate mortgage and the Bank Base Rate. With a variable rate mortgage, the margin is around 1.5%, but with a tracker the payable rate could be below the Bank Base Rate or slightly above it. Those people who took out a tracker mortgage when the base rate was 6% about 2 years ago have thus enjoyed a constant lowering of their payments as the Bank Base Rate stands at 3.75%.

There are a few variations in the type of tracker mortgages available. For instance, there is the lifetime tracker, which will track the Bank Base Rate for the entire life of the mortgage. Then there is the tracker running for a set period at an agreed margin above or below the Bank Base Rate and then moves to the lender's standard variable rate. Then there are trackers in which the lender makes a commitment that the difference between the Bank Base Rate and the mortgage pay rate will not exceed a certain level.

Although tracker mortgages seem foolproof, you still need to be on your guard and make sure you read the small print on the mortgage, where an opt out clause could be hidden. For instance, some lenders will guarantee that the pay rate will not rise over 1% above the Bank Base Rate, yet the small print states that in exceptional circumstances the company can waive the guarantee.

You should watch out for redemption penalties and remember that the Bank Base Rate can rise as well as fall - which can make make budget planning difficult.

Pros

The lender cannot widen its margin and charge a penal interest rate.

Cons

Every time the Bank Base Rate goes up, the borrower's mortgage rate and monthly mortgage rate and monthly payments increase automatically.

FIXED RATE

Are you the kind of person that likes certainty? Do you like to know what your monthly outgoings will be? If your largest regular expense is fixed for a period time, would that be a great advantage to you? If so, perhaps a fixed rate mortgage is for you.

A fixed rate mortgage sets the interest rate you will pay for a specified period. This will guarantee the amount that you pay for each month for the agreed period of time. Once the fixed time period is at an end, your repayments will be at the lender's standard variable rate.

The obvious advantage of this is that should you need to budget carefully over the first few years of your mortgage, you will be able to with a fixed rate deal. You will know how much you have to pay each month, and should the base rate rise you will not be caught out with sudden increases in payments. Should the interest rate rise above the fixed rate that you are paying, you will actually be saving money in real terms.

Don't forget that the reverse of this is also true. If the interest rates go down whilst your fixed rate deal is in place, then you will lose out. However, you will at least still know how much money will be coming out of your account each month, and there is a value on that.

The specified period for the fixed rate is usually between six months and up to five years. In order to take advantage of the best rates, you should look at the deals from one to three years. Some lenders will offer some very long term fixed rates, such as 10 years or even for the life of the mortgage term.

In order to decide how long you want your fixed rate to last for,depends upon what you think will happen to the Bank of England interest rates - do you think they are going to go up or down? If you think they are about to go up then a fixed rate is a great idea, if you think they will go down, then a fixed rate is still Ok, as long as you value the comfort of knowing what your repayments will be.

Look out for redemption penalties at the end of the deal, they could negate any advantages

CAPPED RATE

A capped rate mortgage puts a maximum limit on the payable rate you have to pay.

However, should the lender's standard variable rate be below the level at which the cap is set, you get to pay that amount. This is a product that puts together one of the most attractive aspects of a fixed rate mortgage, that you know where your mortgage is going to rise to at worst and are guaranteed it not going any higher, with a variable rate mortgage, where if base rates go down, your mortgage pay rate will follow it down.

Capped rate mortgages usually last for a few years. This is on average around five years, but it is possible to find capped rate mortgage lasting for the entire life of the loan. Furthermore, the added sophistication of the mortgage market means that you can get some capped rate mortgages with introductory discount periods.

A further development of the capped rate mortgage is the 'Cap and Collar' mortgage, which is when you have a cap limiting the maximum pay rate, and a collar, limiting the minimum pay rate. This product means that you are hedging your bets in both directions, and will mean that your cap is set lower than with a normal capped mortgage in return for you accepting the collar. As long as the cap and collar period exists, your mortgage rate will remain within a set margin.

Pros

When interest rates are likely to rise, they offer protection for borrowers against repayments going over a certain level.
It makes it easier to budget for your expenses when you know what is the highest amount your payments could be.

Remember that in addition to this, you can enjoy the benefits of any cuts made to the lender's SVR.

Cons

The rate payable on them is still usually higher than that available on comparable fixed or discounted rate products. This is even with the existence of discounts in conjunction with the caps.

A conservative choice, as you won't get the cheapest rate on the market.

Should the rate go higher than your cap level, you would have been better off with a fixed rate mortgage, and if the rate falls, a discount mortgage would have been better value.

Look out for redemption penalties, during both the capped period, and also overhanging after the cap rate is finished.

Redemption Penalties

If the lender offers a fixed, capped or a discounted variable rate mortgage, it may charge a stiff penalty if you decide to cash in on your loan before the fixed rate or discounted rate period has run out. This penalty usually amounts to three or six months gross interest. Watch out, as some lenders charge a redemption penalty even after the fixed rate or discounted rate period has run out (overhanging redemption penalties).

Methods Of Paying Interest

VARIABLE

Pros

Cons

FIXED RATE

CAPPED RATE

Pros

Cons

Redemption Penalties

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