Types of mortgages




Calculating interest

Once you've decided to take out a mortgage, think about the different methods of paying interest on the loan.

Borrowers who choose a variable rate mortgage pay the lender's standard variable rate (SVR) of interest. Opt for a lower interest rate package offered as a special deal by your lender and the payments usually revert to the SVR once the agreed period is over.
The SVR is normally between two and three percent above the base rate set by the Bank of England. Lenders can raise or reduce the SVR in line with any changes in the base rate.
It is usually possible to pay a lower rate of interest by opting for a special deal.

How interest is calculated

With standard mortgages, most banks and building societies calculate your interest payments on an annual basis. At the end of each year, your mortgage balance is assessed and used to set the interest payments. This method takes no account of the fact that over the next 12 months you might reduce the amount you owe.

Daily or monthly interest mortgages calculate the interest chargeable more frequently, so you pay less interest and can reduce your mortgage balance more quickly. This reduces the amount of interest payable over the life of the loan still further.

Most lenders have special products that work on this basis, but this is the exception rather than the rule, so check in advance.

The choice is yours, but choose wisely
There are a wide variety of options around, all you need to do is decide which one suits you best. Although some deals are exclusive to first-time buyers, many lenders will offer special deals to those looking to remortgage (that is, move their mortgage to a new lender without moving house) or those moving home.

Many lenders offer customers who come to the end of existing special offers the opportunity to take advantage of a new offer.

When taking out a new loan, think about asking the lender if they will offer special rates in future. Deals include:


Fixed rate mortgages


Fixed rate mortgages are suitable for those who prefer to know exactly what their monthly outgoings will be. These types of mortgage allow a set rate of interest at a certain percentage for an agreed period.

Generally speaking, the most attractive rates are offered for short-term fixed rate loans and the less attractive rates are for longer-term fixed rate loans.

Remember, if interest rates fall, you may miss out on a cut in your monthly payments.

If you decide to repay your mortgage during the fixed rate period you will have to pay an early redemption penalty.

At the end of the fixed rate period your mortgage will normally revert to the SVR unless you approach your lender for another special deal or decide to re-mortgage elsewhere.

Tip: Watch out for expensive early redemption penalties. You usually have to pay penalties if you pay off the loan during the fixed period, but some loans have penalties that extend for several years beyond.

Discounted mortgages


These give borrowers a discount off the lender's standard variable rate (SVR) for a set period. The rate you pay moves up or down in line with any changes to the SVR. When the discounted period ends, you normally revert to paying the SVR.

This type of loan is cheaper in the beginning and allows you to take advantage of any interest rate cuts. But if interest rates rise, your monthly payments go up.

Discounted mortgages usually have early redemption penalty charges during the discounted period and these may extend beyond the discounted period if the loan is particularly cheap.

A typical discount is usually around two per cent below the lender's SVR.

Tip: Don't just choose the cheapest mortgage rate available; look closely at the period of the discounted rate, redemption charges, lock-in periods and other hidden costs.

Capped rate mortgages


These combine the best features of fixed and discounted mortgages. The top rate you pay is fixed or 'capped' at a certain level for a set period.

If interest rates fall during that time, your monthly payments should fall in line with any changes to the lender's SVR. This makes capped mortgages suitable for someone on a limited budget, enabling them to benefit from interest rate falls but protecting them from any rises.

However, like fixed and discounted mortgages, their terms also usually include charges for early repayment, often called early redemption charges (ERCs).

Tip: If you are a first-time buyer, or your income is likely to fluctuate, the stability offered by a capped rate can be attractive if interest rates rise in future.

Cashback mortgages


Great for first-time buyers, those on a tight budget, or those who have taken out a loan to use as a deposit for the mortgage.

Once the deal is done, your lender will reimburse a certain proportion of your mortgage loan. This could be as much as a couple of thousand pounds, depending on the lender and the size of the mortgage.

Cashbacks were previously available only on variable rate mortgages but can now also be taken out in conjunction with any of the other special deals. The downside is that, by taking the cashback, the rate of interest you pay is likely to be less attractive than a non-cashback loan.

If you repay part of the loan or redeem it in full during an initial period, you may well be asked to pay back some or all of the cashback payment.

Tracker mortgages


The Tracker mortgage normally follows movements in the base rate set by the Bank of England. The interest rate is set at a constant level above or below the base rate, rising and falling in line with any changes during the tracking period.

This means that if the base rate falls, the amount you pay falls. Likewise, if the base rate goes up, so will your payments.

Tracker mortgages tend to be for a fixed period, say five years, after which you usually transfer to a new tracker rate, or to a different type of rate altogether.

Tip: Tracker loans often have no early redemption charges if you pay the mortgage off early.

Flexible mortgages


These are a new wave of mortgages specially designed to accommodate the changes taking place in our working environment and lifestyles.

Some mortgages allow you to take payment 'holidays' where you can choose not to make monthly payments for up to six months. This is particularly useful for couples starting a family, or people taking time out to study.

You will have to agree payment holidays with your lender and taking time off could either increase your repayments later on or prolong your loan period.

Some companies allow you to pay off lump sums against your mortgage without charge. This facility is particularly useful for the self-employed and contractors whose incomes may fluctuate.

Tip: If you plan to pay off some (or all) of your loan quickly, choose a flexible mortgage that allows you to overpay without a redemption charge.

Current account mortgages


Several companies offer an extremely flexible mortgage that is linked to a current account. Your mortgage account and your bank account are merged into one and you are issued with a cheque book and cash card just as you would with an ordinary current account.

You pay your salary into the account and a proportion is automatically used to meet your monthly mortgage repayment. You can pay as much off your mortgage as and when you like, according to monthly minimums.

At any time you can borrow back some or all of the money you have managed to overpay. These mortgages are ideal for those paid regular bonuses who can reduce the mortgage balance quickly.

Tip: Make a list of all your monthly outgoings and make sure you borrow what you can afford rather than what the lender will give you.

Early redemption Charges


The downside of all discounted, fixed rate and cash-back mortgage deals is that lenders need to recoup some of the costs incurred in attracting customers.

Most lenders add an early redemption charge.

If you borrow under a special deal and redeem the mortgage in full or in part during the initial period, you pay a charge based on a percentage of the amount you repay.

If you plan to redeem your mortgage in its early days, you should check to see what early redemption charges (ERCs) apply.

Some lenders apply the ERC after the initial special deal has finished. For example, you may have a fixed rate deal that reverts to the SVR after three years. You will then be required to remain on the SVR for a specified period of time before you are allowed to redeem your mortgage, or even move to a more competitive rate.

Tip: Make sure you can afford your mortgage payments after any special deal has come to an end.

Insurances and guarantees


Mortgage indemnity guarantee
A mortgage indemnity guarantee (MIG), also known as a High Percentage Loan Fee, is normally charged to borrowers putting down deposits of 25 per cent or less on their homes. These insurance premiums (which often cost thousands) ensure that if the property is repossessed by the lender and sold for less than the mortgage balance outstanding, the lender can claim any loss against the policy.

Although the borrower pays the premium, the policy doesn't protect the borrower personally. The insurance company can pursue you for any losses it incurs.

Fewer lenders now charge MIG premiums given the buoyant property market, generally more responsible lending practices and the wider take-up of mortgage payment protection insurance. Make sure you check this with the lender.

Buildings and contents insurance
Many lenders offering cheaper mortgage deals make it a condition that you purchase their own buildings and contents insurance. Often they do offer good quality cover, however, the price can be higher than a policy bought from another company.

Check the cost of the loan without the lender's cover and compare this with a home insurance policy bought from another provider before entering any deal.

For your protection


Accident, sickness and unemployment cover
While Accident, Sickness and Unemployment (ASU) cover can provide valuable peace of mind and pay your mortgage if you are unable to work, it can be expensive if bought direct from the lender. Shop around as costs and quality of cover can vary.

Valuation fees
Your lender will want to make sure that the property you want to buy is at the very least worth the money you are borrowing. A Valuation for Mortgage Purposes (VMP) will be required.

The valuation is purely for the lender's benefit and even though they may give you a copy, it is unlikely to tell you a great deal about the property. These valuations normally cost only a few hundred pounds and many lenders offer to refund this upon completion.

Depending upon the age and condition of the property, it often makes sense to opt for a more detailed homebuyer's report, or even a full structural survey.

The homebuyer's report will include the lender's valuation and provide a fairly detailed overview of the condition of the property. Though this is not a structural survey, it will help to make you aware of any potential problems you may inherit from the previous owner and can be a useful bargaining tool.

A full structural survey is the most expensive report you can have done and the fee will normally depend on the individual property. If you are concerned about the structural integrity of the property, or it is situated in an area with a history of subsidence problems, a structural survey can help you avoid potentially huge bills later on.

Booking fees


If you wish to take advantage of a special mortgage deal you may be required to pay a one-off booking fee to secure your entitlement to the funds. Normally you are required to finalise your mortgage transaction by a certain date. Be sure to check all the terms and conditions applicable to the booking rate before you pay.

Here's how you pay it back:
  • The repayment mortgage (capital and interest) - With a repayment mortgage, your payment is split into two parts every month: one to pay off the interest and the other to pay off some of the loan.
    This is the only method that ensures your mortgage is paid off by the end of its term.
  • The interest-only mortgage - As its name suggests, you simply pay off the interest on your mortgage ach month, and none of the loan is repaid. You take out investments to build up the capital to pay off the loan at the end of the term. These can be riskier than repayment mortgages but you will pay less money directly to the lender each month. This is because you only pay the interest on the loan. The original sum borrowed doesn't have to be paid off until the end of the mortgage term.
Consequently, in conjunction with your mortgage, you will need to take out some form of savings plan into which you save enough money to repay your mortgage by the end of the loan period.

Of course, if you have another method of generating the capital required to pay off the loan at the end of the term, you may not need to set up a savings fund. Talk to your lender. If in doubt, you should set up a suitable investment plan to build up funds to repay the loan.

There are three main savings schemes:
  • Individual Savings Accounts (ISAs)
  • Personal Pensions
  • Endowments
Tip: You should only opt for an interest-only mortgage plus an equity-based saving scheme if you can tolerate an element of risk. If the thought of losing some of the money you are investing, worries you, stick to a repayment mortgage.

Individual savings accounts


Individual Savings Accounts (ISAs) are the newest form of tax-free saving and investment and were introduced in 1999 to replace Personal Equity Plans (PEPs).

They can be used as mortgage repayment savings plans. Although they don't have life insurance automatically built into them like endowments, they can work out cheaper and generally give you a wider choice of investments.

ISAs invest most of your money into stocks and shares, which means they can grow very quickly if the stock market performs well and could enable you to pay off your mortgage early.

On the other hand, if there's a stock market slump, there's a risk that you may not be able to pay off your loan at the end of its term.

With ISAs you can raise or reduce your monthly payments (subject to contract limits), put in lump sums, or even stop contributions altogether. Of course, reducing or stopping your contributions could mean that you fail to save enough to pay off your mortgage loan, so you need to manage your ISA properly.

Advantages
  • ISAs can outperform other types of savings but there is no guarantee of the level of return
  • ISAs can be a tax-efficient way to save
  • You may be able to pay off your mortgage early
  • They tend to be flexible
  • You can transfer your ISA from one fund manager to another

Disadvantages
  • Risky - there is no guarantee of the level of return you will receive
  • You need to arrange separate life and ill health cover
  • You cannot invest in with-profits funds within an ISA
  • Flexibility could mean temptation to draw on the funds
  • There's no guarantee ISAs will continue after 10 years
  • 10 per cent tax credit on dividends is available only until 2004

Pensions


Another option is to link your mortgage savings to your pension. Pensions are one of the most tax-efficient ways of saving.

Not only do your contributions qualify for tax relief, but your investment is also allowed to grow almost entirely free of tax. Once you retire, you are allowed to take part of your pension as a tax-free lump sum. This can be used to repay your mortgage.

However, this option may only be suitable if you are able to pay enough money into your pension - to cover both your future income needs as well as your mortgage needs.

Another thing to remember is that pensions can be inflexible - you won't be able to take your money out until you retire. With most personal pensions, this isn't until you reach the age of 50, while some company pensions don't let you take money out until you're older.

Advantages
  • Contributions into your pension plan could receive substantial tax benefits
Disadvantages
  • It can reduce the size of your pension income unless you take this into account in your contributions
  • Pensions can be inflexible
  • You have to wait until you retire before you can pay off your mortgage - this may be too long a time for younger customers
  • You may have periods of ineligibility for certain pension schemes
Tip: Pension payment plans may be an attractive option for higher rate taxpayers, who get 40 percent tax relief.

Endowments


Endowments are specifically designed for mortgage repayment, so they do make the process simple.

You pay a monthly premium into an endowment insurance policy, most of which goes into an investment-linked savings plan, while the rest is used to buy life assurance cover to pay off your mortgage should anything happen to you. At the end of the mortgage term the endowment policy matures and the proceeds are used to pay off your loan.

The endowment company will work out how much you should pay each month to build up a big enough sum to cover your mortgage. This is based upon your age, the mortgage term, the amount you are seeking to save and, perhaps most important, an assumed rate of growth.
Most companies offer either with-profits or unit-linked endowments.

Advantages
  • Depending on the investment performance, endowments may grow faster than expected - you may be able to pay off your mortgage early
  • Life cover is built in and ill health protection is easily added
  • They encourage long-term saving
  • With-profits funds can help smooth out investment risk and lock-in returns
Disadvantages
  • Endowments rely on stock market growth, so can be risky. Your investment could go down leaving you without enough money to pay off the mortgage at the end of the term. You will be liable for any shortfall
  • They can be costly
  • They are inflexible
  • They can impose heavy penalties if you try to cash in the policy early

Get protected


Once your mortgage is lined up and you have chosen how to repay, there is still more to consider.

Once you've made it to the other side you'll want to know that you can meet your repayments if anything goes wrong. Luckily, there are a number of products designed to help out with your mortgage if you can't work or earn:
  • Accident, sickness and unemployment cover (ASU)
  • Income replacement insurance
  • Life assurance
  • Critical illness cover
Accident, sickness and unemployment cover
Also known as mortgage premium protection insurance, Accident, Sickness and Unemployment (ASU) cover pays your monthly loan repayments if you fall ill, have an accident or are made redundant.

You can choose to take cover against the risk of unemployment only, or accident and sickness only. Cover is generally limited to one or two years and can be expensive.

The self-employed or those with limited sickness benefits from their employer should consider more substantial protection in the form of income replacement insurance (IRI) policies, which generally provide more substantial benefits over a longer term.

Life assurance


Your family, your health and your home are probably the most important things in your life, so you'll want to take steps to protect them and make sure they are adequately covered in case anything goes wrong.

Always ensure you can answer the following questions with a resounding 'yes':
  • If I die, my capital debts will be repaid
  • If I die, my dependants will not suffer a big drop in their standard of living in the short/long term
  • If I can't work because of ill health, my monthly bills will continue to be paid until I return to work
  • If I can't work again, my debts will be repaid and I will have adequate resources on which to live
The idea is that you or your family can continue to meet the monthly bills and other financial commitments if there is no longer a regular income.

If you are using an endowment to repay your mortgage, the policy will automatically include life cover.

It makes a lot of sense to ensure that you and your partner both take out life assurance, particularly if the mortgage is in joint names.

Protect your health


Critical illness cover pays you a one-off lump sum if you are diagnosed as having a particularly serious illness. Each company will provide a list of applicable illnesses and will usually include heart-attack as well as permanent and total disability.

Unlike life assurance, critical illness cover provides a cash lump sum for policy holders to benefit from while they live.

If you become seriously ill or disabled and cannot work, critical illness cover could repay your mortgage.

Critical illness cover does not have to be expensive if you arrange it at the same time you arrange your mortgage. Make sure you compare the range of illnesses and conditions covered in the policy before you sign up for it.

Waiver of premium insurance
Not commonly understood or even discussed, but a must if you are taking out any endowment, life assurance or pension contract, if it is available - especially where a mortgage is involved.

Waiver of premium insurance protects your policy premium. If you are unable to pay your premiums due to an illness or injury that prevents you from working for a while, the insurer will waive your premiums and pay them on your behalf.

The cost of this extra benefit is generally low and is added on to your overall premium.







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