Before 2008, the big choice for homebuyers was between interest-only mortgages and repayment mortgages. Now, it’s between tracker mortgages and fixed-rate mortgages. Both tracker and fixed-rate mortgages can be (and usually are) issued on a repayment basis. There are, however, significant differences in what they can mean for your finances.
The basics of trackers vs fixed-rate deals
Tracker mortgages are set at a certain percentage above the base rate. Fixed-rate mortgages have a set mortgage rate.
Both tracker and fixed-rate mortgages are issued for an agreed term. This is typically (much) shorter than the mortgage amortisation period. For example, a term may last one to five years. A mortgage amortisation period may be twenty to thirty years. After this, borrowers either get a new deal or go onto the lender’s standard variable rate.
What this means in practice is that tracker mortgages directly push the risk of interest-rate rises onto the borrower. If interest rates go up, the lender simply increases the borrower’s repayments to compensate. Fixed-rate mortgages push them directly onto the lender. Indirectly, however, they are still pushed back onto the borrower.
The reality of fixed-rate mortgages
At the end of the day, commercial lenders, by definition, are in business to make money. Part of this means avoiding excessive risk-taking (especially in the light of 2008). They are therefore going to be very careful to avoid setting fixed-rate deals overly low. In other words, they are going to make sure that they have breathing space if interest rates go up.
This means that, realistically, borrowers should not expect to get significant protection from interest-rate rises. They should also be clear on the fact that they will not benefit from interest-rate falls. The term “fixed rate” means exactly what it says. At most, they will come out more or less even. They will pay less if rates go up but more if they go down.
Realistically, they have to consider the possibility that the lender’s margin of error (or margin of safety), will result in them paying more overall. For some people, this may be an acceptable trade-off. If you’re on a fixed income, then knowing what you’re going to pay from one month to the next can make it much easier to budget.
For others, however, paying interest to a lender when you don’t have to is totally unacceptable. It’s a waste of money that the borrower could have used for other purposes, be that work or play. In fact, it could even lead to borrowers spending much more than they needed to on their mortgages.
The importance of mortgage terms
Like everybody else, lenders find it easier to see into the near future than the distant future. That’s why mortgage terms are generally much shorter than the mortgage amortisation period. Essentially, at the end of each term, the borrower renegotiates their mortgage.
On the one hand, this approach creates extra administration for both lenders and borrowers. On the other hand, it also promotes safety for both of them. From a lender’s perspective, it limits their exposure if circumstances change either in the market or for the borrower.
From the borrower’s perspective, it means they can leverage the equity they are likely to have built up in their house. This will lower the loan-to-vehicle ratio and hence potentially give them access to better deals. The more borrowers have managed to pay down their mortgage, the better a position they will be in.
This is why borrowers on tracker mortgages could end up substantially better off than borrowers on fixed-rate deals. If they manage their finances well, they can pay down their mortgages quicker. This minimises the amount of interest they pay to their lender and, hence, leaves them better off overall.
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