What is a discount mortgage and is it right for you?
Discount mortgages are often attractive for their low interest rates, but there are a few downsides to consider too.
A discount mortgage is essentially a home loan where the interest rate is set at an amount below the lender’s standard variable rate (SVR).
This could be for either a set period (two or five years) or for the whole mortgage.
The SVR is an interest rate set by your lender, which it can raise or lower by any amount, at any time.
However, a discounted mortgage is a type of variable-rate mortgage, meaning the amount you pay could change from month to month.
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How do they work?
When you repay your mortgage, part of the money goes towards the interest charged by your lender and the other part towards repaying the money you’ve borrowed.
The saving you make on a discount mortgage only applies to the interest that you pay.
In this case, if a lender has an SVR of 5% and the discount is 1%, the interest rate you will pay is 4%.
If your lender raised its SVR, let’s say to 6%, your discounted interest rate would also rise, in this case to 5%.
If your interest rate increased, your monthly mortgage payments would go up too but you would be paying more interest, rather than repaying more of the money you’d borrowed.
When does a discount rate change?
Discount mortgages are not affected by the Bank of England base rate. Instead, they always mirror the lender’s SVR, which can go up or down at anytime.
For instance, if several big lenders increase their SVR, their discount mortgages will also increase, even if the base rate hasn’t moved for years.
What’s the difference between discount and tracker?
Trackers and discount mortgages are often classed as virtually the same thing, with discount mortgages being marginally cheaper.
But the difference is that a discount mortgage tracks your lender’s SVR, rather than the Bank of England base rate.
To decide which of these options you should choose, you’ll need to work out whether you’re prepared to risk your lender putting up the rate in return for the savings offered with a discount mortgage or if you’d rather pay marginally more in order for your interest rate to be pegged to the base rate with a tracker mortgage.
You may prefer a tracker deal because it is possible to make an educated guess about when the Bank of England base rate is going to change, while it can be almost impossible to tell when a lender will change its SVR.
What do I do when my discount mortgage ends?
Discount mortgage deals are usually offered for somewhere between two and five years.
The longer the discounted period, the smaller the amount the discount tends to be.
When this timeframe comes to an end, your lender will usually transfer you onto its SVR automatically.
This means that your monthly repayments will increase, as you’ll be paying a higher rate of interest.
At this point, you should think about remortgaging to find a better new deal.
What are the other factors to consider?
As with any mortgage, you need to ask yourself a set of questions, like these below:
How much can I borrow?
It’s a good idea to use a mortgage calculator to get an idea of how much you can borrow, according to your salary. This will help you to work out the price range of houses.
How much equity do I have?
This refers to the proportion of your home that you own outright, without a mortgage.
Let’s say someone is buying a £100,000 house with a £25,000 deposit, meaning they have 25% equity. Therefore, the more equity you have, the lower your mortgage rate will be.
How long should I get one for?
Most first-time buyers have a mortgage term of 25 years, although their initial interest rate is likely to only last two, three or five years.
This means the entire debt will be paid off at the end of the 25-year period.
Generally speaking, it’s preferable to go for the shortest term you can afford, in order to pay less interest and pay off the debt quicker.
How much can I afford?
When choosing the type of mortgage for you, have a play with a mortgage calculator to see if you could afford the monthly payments if a discount mortgage went up.
This is really important because if a discount mortgage would already stretch your monthly budget to the max, you should borrow less and consider a fixed-rate term for greater peace of mind.
Factor in fees
But some of the very cheapest mortgages have huge fees that can run into thousands of pounds.
In these cases, it may be better to do your homework and opt for a mortgage with a higher interest rate, but one with lower fees.
Which fees have to be paid?
Mortgages come with a variety of fees that you need to pay attention to.
Often, a lender will advertise a rock-bottom interest rate to draw in customers, but they’ll rack up the fees to ensure they aren’t making any less money on the deal.
Below are the main bulk of fees to watch out for:
This is the lender’s charge for the administration of setting up your mortgage. These have crept up in recent years and some can be as much as £2,000.
You don’t always have to pay for this upfront as it can be added to your mortgage. But just bear in mind that this means you’ll pay interest on it, increasing the overall cost of your mortgage in the long run.
Early redemption charges
If you want to leave your deal early many lenders will penalise you. You’ll also trigger a penalty if you pay off your mortgage entirely and, sometimes, if you try to overpay.
The penalty can be calculated in a variety of ways:
- A percentage of the original loan
- A percentage of the balance still owed
- A percentage of the amount you’ve already paid
- A number of months’ interest
- A fixed fee
This is perhaps the most important charge to check. Many lenders charge a fee to close a mortgage when you’ve paid it off.
Despite brokers estimating that it costs lenders around £50 to close off a mortgage, this fee has soared recently with some mortgages carrying a £200 fee.
The regulator has stated that lenders must not profit from this fee, although they are yet to act against those charging large amounts.
To avoid this, make sure you check what you’ll pay before you accept a mortgage offer.
It’s possible that this may be masquerading under another name too, so look out for a deeds fee, discharge fee, redemption fee, sealing fee or vacating fee.
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