At a basic level, interest rates are easy to understand. The higher they are, the more the borrower pays the lender and vice versa. In the real world, however, there can be a lot of nuance. With that in mind, here’s a quick look at the main types of mortgages and how interest rates apply to them.
Interest-only mortgages
With interest-only mortgages, you pay back the interest each month and the capital at the end of the term. This means that your monthly repayments will be lower than they would be for an equivalent repayment mortgage.
On the other hand, you never reduce the amount borrowed over the term of the loan. In other words, you’re always paying interest on the amount you originally borrowed. This means that what you end up paying overall will be more than with an equivalent repayment mortgage.
Offset mortgages
With an offset mortgage, the borrower keeps their savings with their mortgage lender. The savings balance is used to offset the mortgage balance. In other words, borrowers forgo interest on their savings in exchange for paying less interest on their mortgage. Some offset mortgages also permit borrowers to link their current accounts to their mortgage balance.
For practical purposes, offset mortgages are simply a method of calculating how much interest is due on a loan. In principle, they can be offered as interest-only or repayment, fixed-rate or variable rate. It all depends on the lender’s view of the market (and the individual borrower).
Similarly, the benefits of an offset mortgage have to be considered in context. For example, the ability to reduce the amount of interest payable is a benefit. If, however, the interest rate charged is significantly higher than with other products, this benefit may be negated.
Repayment mortgages
With repayment mortgages, monthly repayments cover the interest and a portion of the capital. This means that they are higher than the monthly repayments for interest-only mortgages. On the other hand, it also means that the amount borrowed reduces over the course of the mortgage. This means that, overall, you will pay back less than with an equivalent interest-only mortgage.
It also means that you build up equity in your home more quickly. With interest-only mortgages, your equity is basically the amount of your deposit plus any increase in the value of your home. With repayment mortgages, you get this, plus the equity you build up through making capital repayments each month.
The more equity you build up, the lower your loan-to-vehicle ratio becomes. This can make it possible for borrowers to remortgage at better rates.
Fixed-rate and variable-rate
Fixed-rate mortgages, as their name suggests, have a set rate for a set period. This means that they won’t go up during that period. It does, however, also mean that they won’t go down either. Right now, that might seem like a moot point given how low-interest rates are. It is, however, worth remembering in general terms.
Variable-rate mortgages, also as their name suggests, charge a level of interest that rises and falls in line with the base rate charged by the Bank of England. Depending on circumstances, this could make them (much) more expensive than fixed-rate mortgages. On the other hand, it could also make them (much) cheaper.
In general terms, neither type of interest rate is better or worse than the other. In specific terms, however, some borrowers might very much prefer the consistency of fixed-rate mortgages. Others might prefer the flexibility of variable-rate mortgages.
The key point is to get the best possible deal for your situation. As a minimum, this usually means that you have to stay off your lender’s standard variable rate. This can be much higher than the best deals on their books, let alone the best deals on the market.
Your property may be repossessed if you do not keep up repayments on your mortgage.
The FCA does not regulate some forms of buy to let mortgages.
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