Guide to interest rate types
Although there are many different types of mortgages available they boil down to a small handful of interest rate types. Interest rate types or interest rate scheme as they are also known is basically the way in which a lender charges you interest on your mortgage.
There are 6 types of schemes. Click on each one to be taken to the relevant section.
Standard Variable Rate (or Variable rate for short)
The Standard Variable Rate (SVR) is the rate of interest you will be charged on a lender's standard mortgage (not special deal mortgages such as fixed, capped, discounted, or those which track an external rate). 'Variable' means the rate can go up and down.
This is basically a lender's no frills product without offering any special deals. Your payments go up and down as the mortgage rate changes.
Mortgage rate movements usually respond to changes in the base rate set by the Bank of England's Monetary Policy Committee.
Pros
- You're not tied in to the mortgage so you can change it at any time without being penalised for doing so or paying early repayment charges.
- This is good for situations in which you plan to sell the property soon and may not wish to be tied in to a mortgage for a long time.
Cons
- Unless you plan to sell the property or change the mortgage very soon then there are no advantages to having a standard variable rate.
- The rate is higher and you could make more savings and have lower payments by taking out one of the other interest rate schemes.
- Also your payments may rise if mortgage rates rise. So unless you can afford increases in your payments, you may be better off with a mortgage where the rate is fixed for a period of time (giving you time for your income or earnings to increase).
Discounted Rate Mortgages
Your payments are based on a discounted rate set at a certain level below a variable rate for a specific period of time, which means your payments may go up or down. For example a 1% discount for 12 months off a variable rate of 5% would mean a pay rate of 4% for12 months.
Sometimes these discounts are stepped over a period of time, for example a discount of 2% in year one followed by a discount of 1% in year two. After the set period the full variable rate usually applies.
Pros
- Provides you with lower payments in the early years to help with the cost of moving or setting up in your new home.
- A discount that gradually reduces means you do not usually face a significant increase in payments when the discount period ends.
Cons
- If interest rates rise whilst you are on a discount, your payments may increase.
Fixed Rate Mortgages
The monthly interest rate will stay the same for a set period of time, for example between 2-5 years. At the end of the fixed rate period your rate will usually change to the lender's Standard Variable Rate. Your monthly mortgage payments will stay the same for a set period of time.
Pros
- You are guaranteed that your rate will be exactly the same every month for the duration of the fixed rate term - even if other interest rates rise during this period.
- You can confidently plan your budget for the whole period, because you'll know in advance exactly what your major outgoings will be.
- This is good especially for first time buyers who want to get used to having a mortgage for the first time and hence want to know what they'll be paying exactly in order to budget effectively.
Cons
- If other interest rates fall during the set period, then the amount you pay during the fixed rate term may be higher than if you had chosen a mortgage type where the interest rate is allowed to rise and fall.
Tracker Mortgages
Your interest rate tracks the Bank of England base rate exactly. For example your interest rate might be set to be always 1% above the Bank of England base rate. This can either be for a set period of time such as 3 years or for the life of the mortgage.
Pros
- Your rate will reflect the Bank of England base rate. This means when the base rate falls, you are guaranteed to benefit from the rate reduction in full immediately.
Cons
- If the base rate rises, your rate will automatically rise so you may find you are paying a rate which is higher than other variable rates.
Capped Rate Mortgages
Your payments are linked to a variable or tracker rate which means that payments can go down as well as up - but the amount the rate can rise to is restricted to an upper limit (known as the 'cap' or 'ceiling') for a set period of time.
There is a similar mortgage called a Cap and Collar mortgage, where the rate you pay does not fall below a lower limit (known as the 'collar' or 'floor'). At the end of the cap (and/or collar) period you are usually charged at the variable rate.
Pros
- These mortgages provide certainty that the variable rate charged to your mortgage will not rise above the cap. This means you are protected from significant rises in variable rates. This will help you to budget.
- In addition, you will be able to enjoy a lower rate if interest rates fall.
Cons
- Less common nowadays than before due to limited benefits compared to fixed rate mortgages.
- May not be as beneficial as a fixed rate mortgage if rates rise, as the upper limit of a capped rate is often higher than a fixed rate. For example, if the variable rate rises to the cap level and remains at this level for a significant period of time, then a fixed rate mortgage below this level may have been better value.
Flexible Mortgage
This type of mortgage allows you to overpay, underpay and take payment holidays on your mortgage. By overpaying above your normal monthly mortgage payments you are reducing your mortgage balance and hence paying off your mortgage sooner.
Also during difficult times, you can pay less than your usual monthly mortgage payments and even take a break from your monthly payments completely for a set period of time.
This is only possible if you were overpaying in the first place.
So for example let's say your mortgage was for £100,000 and your normal monthly payments are £600, if you were paying £750 a month - overpaying by £150 a month then in 12 months time you could pay less say £400 a month for a few months, or take a break from making payments for a month or two.
An extra feature is that you can also borrow back some of the payments you have made instantly but this depends on how much equity you have in your property.
Pros
- Allows you to make overpayments and thereby reduce your mortgage more quickly than by not doing so. This way you reduce on interest payments on your mortgage in the long run and reduce the duration of your mortgage.
- Also being able to borrow more instantly saves you the hassle of having to apply for further borrowing as it's available as and when you need it.
Cons
- Flexibility comes at a price and Flexible mortgages have a higher interest rate than other types of mortgages - particularly Fixed or Discount mortgages.
- The flexibility is only of benefit if you make consistent overpayments and actively plan on reducing your mortgage quickly. Otherwise you will be paying for a feature you are not using and would be better off with either a fixed or discount mortgage.