Different types of mortgages

With so many different types of mortgages, lenders and even deals, looking at mortgages can feel overwhelming. Taking advice from an independent mortgage broker can be a good idea.

To get you started, this article will walk you through the main types of mortgages on offer, how they work and their pros and cons.

See our range of mortgages

How mortgages work

When you take out a mortgage you agree an overall term, such as 25 years.

If you take out a fixed rate mortgage, it will usually be over a shorter period, for example, two, 3 or 5 years. At the end of the fixed rate period many borrowers switch onto a new product deal to avoid potentially going onto higher standard rates set by the Lender.

How interest on mortgages is charged

The mortgage deals you can choose from come in many different shapes and sizes and can last for one year up to 15 years or even longer.

The lender charges you interest on what you borrow, and your rate of interest can be fixed or variable dependent on the mortgage product you choose.

Let’s run through the most common types:

Fixed rate mortgages

A fixed rate mortgage is where your interest rate is set for an agreed period. A two-year fixed rate at 3% for example simply means you pay an annual interest rate of 3% for 2 years.

Whilst within the fixed rate period, your mortgage rate will not change, no matter what happens to the wider economy and interest rates.

At the end of the fixed rate you can switch to a new mortgage deal, or you will automatically move onto your lender's Standard Variable Rate.

Pros and cons

Fixed rates are very popular and can have clear benefits:

• You know what your monthly mortgage repayments will be for a set time
• Your rate won’t go up no matter what happens to wider interest rates
• You can budget over the period you have fixed because you have certainty of payment.

However, there can be some downsides to consider:

• You won’t benefit if interest rates fall and may feel you are paying over the odds
• Most fixed rates charge you a penalty to leave the deal before the end of your agreed period, called an Early Repayment Charge
• Variable rate mortgages do not usually have any Early Repayment Charges, therefore offer more flexibility if you want to redeem the mortgage or make overpayments
• At the end of the fixed rate deal you may find that rates have increased and therefore may impact your monthly mortgage payment.

Who do they suit?

Nearly all borrowers suit fixed rate mortgages. They are easy to understand and offer peace of mind that your monthly repayments are set in stone.

They are particularly useful for first-time buyers who are dealing with other costs of buying, decorating and furnishing a home. Fixed rates allow you to budget and plan your finances.

Find out more about our fixed rate mortgages

Variable rate mortgages

A variable rate mortgage goes up and down in line with wider interest rates which means your mortgage rate could change.

You take out a variable rate over an agreed period, such as two years or five years for example. At the end of your deal period you may move automatically onto the lender’s SVR unless you remortgage.

There are different types of variable rate:

• Standard variable rate (also known as “SVR”): This is the lender’s default rate which you will move onto at the end of a special deal. It is usually more expensive than other types of mortgages.
• Discounted rate: A discounted rate is literally a discount from the lender’s SVR for an agreed period. It might be a 2% discount from the lender’s SVR for two years, after which you move onto the SVR, or you can remortgage.
  
  Your pay rate goes up and down in line with the lender’s SVR, according to your set discount.
• Capped rate: A capped rate is like a discounted rate although there is a maximum, above which your rate can’t go, known as the cap.
• Tracker: A tracker rate can also move up and down, but it is linked directly to the Bank of England’s Bank Rate, (known as the base rate). It is tied to the Bank Rate at a set margin, such as 2% above Bank Rate. When the Bank Rate is increased or lowered by the Bank of England your tracker rate automatically follows it at the agreed margin. Tracker rate mortgages are very transparent as the lender doesn’t control your mortgage rate.

See our range of tracker rate mortgages

Pros and cons

Variable rates can have the following benefits:

• If wider interest rates fall your mortgage rate is likely to fall too, reducing your monthly repayments
• Variable mortgages offer more flexibility as usually they don't have Early Repayment Charges if you were to redeem the mortgage early or want to make overpayments above the limits given on fixed rate mortgages.

But there can be drawbacks:

• If rates rise your mortgage payment could rise too and become unaffordable
• You may be tied into a special deal such as a discount and unable to remortgage or switch without paying a penalty, even if rates rise sharply
• Rate fluctuations are subject to market conditions and this can impact your monthly budgeting.

Who do they suit?

Variable rates are suitable for borrowers who are prepared to accept interest rates that go up and down and are happy to accept a level of risk with the mortgage. If rates rise, your mortgage payments could rise, and there may be no upper limit.

Variable mortgages offer more flexibility as usually they don't have Early Repayment Charges should you want to redeem the mortgage early or make overpayments.

However, if you need certainty of payment a fixed rate mortgage may be a better option.

Switching mortgages

When your mortgage deal ends you have two choices:

1. Do nothing and you could automatically move onto your lender’s Standard Variable Rate (known as SVR). This default rate will usually be higher than mortgage rates on new deals and will cost you more. With some deals you may automatically move to another product while others may mature into a tracker product. Make sure you know what to expect when your mortgage deal ends so you can make the right decision for you.

2. Switch to a new mortgage deal from your current or new lender. Moving to a new deal with another lender is called remortgaging. Moving to a new deal with your current lender is called a product transfer or product switch.

Choosing a mortgage

When comparing mortgages, it’s important that you look at those you can get, as not all borrowers are eligible for all mortgages.

If you see a best buy mortgage that looks too good to be true, check the small print. It might require a large deposit, come with high fees or have strict lending criteria.

Most importantly, make sure you look at mortgages within your loan-to-value or LTV bracket. This is the amount you want to borrow as a proportion of the property’s value. It's a bit technical but really important.

Lenders group their mortgages based on your deposit in relation to the price of the property. The bigger the deposit the better.

Typical loan-to-value (LTV) brackets are:

• 95% for those with at least a 5% deposit
• 90% for those with at least a 10% deposit
• 75% for those with at least a 25% deposit
• 60% for those with at least a 40% deposit.

As a rule of thumb, 95% mortgages have higher interest rates as they represent more risk to the lender.

Lenders reserve their most competitive mortgages for borrowers with bigger deposits for this reason. Those with a relatively small deposit will usually pay a premium to reflect the greater risk the lender is taking.

Find out more about loan-to-value ratios in our First time buyer guide

Once you have a better idea of your deposit and therefore the loan-to-value of mortgages that will be available to you, you need to make some decisions about what type of mortgage you want.

Find out more about our mortgages

Repayment or interest-only?

Lenders charge you interest on your mortgage, so you pay them back more than you originally borrowed.

Some mortgages are taken out on an interest-only basis, but most are taken on a capital repayment basis.

Interest-only mortgages

For an interest-only mortgage, each month you only pay the lender the interest on your debt. The amount you owe remains the same and needs to be repaid at the end of the term.

If you borrow £200,000 over 25 years, you pay the lender monthly interest on that mortgage for 25 years. At the end of the term, you still owe them £200,000.

You repay that borrowing from either your own savings or a long-term investment designed to pay off the mortgage (such as an ISA or endowment). You might be able to use an inheritance or sell the property if it has risen in value over the term.

Pros and cons

The advantages of an interest-only mortgage are that you can keep your monthly mortgage repayments low as you are only covering the interest.

This might boost your borrowing power although lenders are cautious on interest-only lending.

The major downside to these mortgages is that your mortgage is not paid off at the end of your term. You have to find the money to repay it.

Lenders will also need to check that you have a suitable and adequate repayment strategy to repay the mortgage at the end of the term as part of your mortgage application.

There is also no guarantee you will be able to sell your property for enough to pay off the mortgage and you can’t guarantee that any investment will grow by enough to pay off your mortgage debt.

You will also pay more interest over the term of the mortgage on an interest-only mortgage than if you’d have taken the same amount of borrowing on a capital and interest repayment mortgage.

Interest-only mortgages carry a risk that you won’t be able to repay your mortgage at the end of the term and you may not be able to remortgage.

Repayment mortgages

Most mortgages are now taken out on a capital repayment basis, which give you more certainty.

The lender still charges you interest which you repay every month. But your monthly mortgage repayment also includes a little bit of the sum you originally borrowed.

Month by month you chip away at the original debt. Over your mortgage term, you will have repaid the whole amount borrowed, plus the interest.

Pros and cons

Repayment mortgages give you certainty that your mortgage will be paid off by the end of your term, as long as you keep up with repayments.

However your monthly mortgage repayment to the lender may be a little higher than an equivalent interest-only mortgage.

Mortgage product fees

What is a mortgage product fee?

The majority of Lenders offer mortgage products with and without fees. This fee is sometimes called an arrangement fee or completion fee and can be either a flat fee such as £999, or a percentage of the amount borrowed, such as 1%.

This fee is usually paid at application stage or you can request to add this onto the mortgage account at completion, however, you will be charged interest on the fee amount over the full term of your mortgage.

You don't have to choose a product that incurs a fee, however, you may find that interest rates on these products may be lower than products without a fee. It’s important to look at the total cost over the deal period to understand the overall costs and compare deals.

How to work out the total cost of your mortgage over the deal period

The total cost is what you pay for a mortgage, including the monthly repayments and the mortgage fee, over the deal period. For a two-year fixed rate, you should work out the cost over two years. For a five-year deal, work it out over five years.

It’s important to take the fee into account because they can be expensive and affect the overall cost of the mortgage.

A fee-free mortgage might seem appealing, but products with a lower mortgage rate and modest fee could be cheaper overall.

Likewise, the lowest mortgage rate may not be the cheapest overall deal if it comes with a large fee.

The lender uses both the fee and the mortgage rate to create an overall deal. You need to consider both too.

If the mortgage comes with cashback or a free valuation, you should also factor that in when looking at the overall cost.

Next steps

If you need help choosing the right mortgage, The Co-operative Bank can give you individual mortgage advice, tailored to your finances and individual needs.

We can also help first time buyers achieve their homeowning dreams and have a wide range of products to help you buy a home.

If you can't pay your mortgage

If you are worried that you won’t be able to pay your mortgage, get in touch with your lender. They will work with you to come up with a repayment plan based on your circumstances.

Find out more

Download our First time buyers guide for more information on buying a house.

You can also find out more about mortgages here