The Truth About Discount Mortgages
Discount mortgages lure borrowers in with tantalising low interest rates, but they have a sting in the tale.You could save a fortune in interest payments but you have to take on more risk in return. Read on to find out all about discount mortgages and whether they are right for you.
What is a Discount Mortgage?
A discount mortgage, also known as a discounted variable rate, has an interest rate that is set a certain amount below the lender’s standard variable rate (SVR). It goes up and down when the SVR moves. The key difference between a discount mortgage and other variable mortgages is that it tracks a rate set by the lender, it's SVR, rather than the Bank of England. This means your bank can change the rate you pay whenever they like as they don't have to wait for the Bank of England to raise interest rates.
How Do Discount Mortgages Work?
Discount mortgage deals can last for two, three or five years, or the entire term of the mortgage, which is typically 25 years.
As with any type of variable mortgage, a discount mortgage means your monthly repayments can go up as well as down. For example, say a lender’s discount mortgage is 3% and its SVR is 5%. This means the discount mortgage is pegged at 2 percentage points below the SVR. So, if the SVR increased to 6%, the discount mortgage rate would also increase to 4%.
When Does a Discount Rate Change?
Discount mortgages are not affected by the Bank of England base rate. Instead, they always mirror the lender’s SVR, which can go up or down at anytime. Several big lenders have increased their SVR – and therefore their discount mortgages – even when the base rate hasn’t moved for years.
Discount vs Tracker
Trackers and discount mortgages are often classed as virtually the same thing, with discount mortgages being marginally cheaper. But the difference comes into the fact a discount mortgage tracks your lender's SVR rather than the Bank of England base rate. You need to decide if you are prepared to risk your lender putting up the rate in return for the savings offered with a discount mortgage. Or, you'd rather pay marginally more in order for your interest rate to be pegged to the Base Rate. You may prefer a tracker deal because trackers follow the Bank of England base rate, and it is possible to make an educated guess about when this is going to change. In contrast, it can be near-impossible to tell when a lender will change its SVR.
Is a Discount Mortgage Right for Me?
Discount mortgages can be a great, cheap deal while they last. But you should only opt for a discount mortgage if you can afford an increase in your monthly mortgage payment. Even a small increase to an SVR of 0.5% can add a significant amount onto your monthly mortgage bill. If you have a £150,000 mortgage paying 3.5% instead of 3% you would pay an extra £40 a month. If you want the peace of mind of knowing your monthly mortgage payments will always be the same over a set period, opt for a fixed rate. Consider a discount mortgage if:
- The deal is going to save you money
- If the SVR did increase, you could afford to pay more every month
Avoid discount mortgages if:
- You would struggle if your monthly payments went up - a fixed-rate mortgagemay be a better option
- You would consider an increase unfair if the base rate hadn’t moved
What Should I Do if My Discount Mortgage Increases?
If a discount mortgage is particularly cheap to begin with, you may be able to stomach a small increase in payments. There may even be no cheaper deals for you to switch to anyway, especially if you have little equity.
- If there are cheaper deals out there, you may be tempted to leave your discount mortgage deal early and switch lenders. But beware – some lenders will sting you with an early repayment charge if you leave a mortgage early. This might be worth hundreds or even thousands of pounds. Always check to see if a discount mortgage has an early redemption charge before signing up.
WARNING: Take Action when a Discount Mortgage Ends
As with any mortgage, when the deal comes to an end you will most likely be automatically placed onto the lender’s standard variable rate (SVR). This means your monthly mortgage bill will increase sharply. For example, if you have a £150,000 mortgage on a discount rate of 3% you’ll pay £711 per month. But if the SVR is 5% it would jump to £877 per month. Don’t get caught out by this. Three to six months before your deal is due to end start shopping around for a new mortgage deal. Consider if you want afixed, trackeror another discount mortgage, and remember to factor in the cost of arrangement fees. If you have at least 20% equity in your home you should be able to get a cheaper deal than your lenders’ SVR.
What Else Should I Consider when Choosing a Discount Mortgage?
As with any mortgage, you need to ask yourself all of these questions:
How much can I borrow?
Use a mortgage calculator to get an idea of how much you can borrow according to your salary. This will help you to work out the price-range of houses.
How much equity do I have?
This refers to the proportion of your home that you own outright, without a mortgage. For example, if someone is buying a £100,000 house with a £25,000 deposit, they have 25% equity. The more equity you have, the lower your mortgage rate will be.
How long for?
Most first time buyers have a mortgage term of 25 years, although their initial interest rate is likely to only last two, three or five years. This means the entire debt will be paid off at the end of the 25 year period. Generally speaking it is preferable to have the shortest term you can afford, in order to pay less interest and pay off the debt quicker.
How can I find the cheapest mortgage?
TotallyMoney.com searches up to 5,000 mortgages to bring you the best deals for the amount of equity you have.
How much can I afford?
When choosing a type of mortgage, have a play with a mortgage calculator to see if you could afford the monthly payments if a discount mortgage went up. This is really important. If a discount mortgage would already stretch your monthly budget to the max, you should borrow less and consider afixed rate for greater peace of mind.
Factor in fees
As we explain below, some of the very cheapest mortgages have huge fees that can run into thousands of pounds. It may be better to opt for a mortgage with a higher interest rate, but lower fees. Check out our guide to free-free mortgagesfor more on weighing up the cost of fees.
What Additional Fees Will I Have to Pay?
Mortgages come with a variety of fees that you need to watch out for. Frequently a lender will advertise a rock-bottom interest rate to draw in customers but they’ll rack up the fees so they aren’t making any less money on the deal. Here are the fees to watch:
This is the lender’s charge for the administration of setting up your mortgage. These have crept up in recent years and some can be as much as £2,000. But you don’t have to pay it upfront. It can be added to your mortgage, but bear in mind this means you’ll pay interest on it, increasing the overall cost of your mortgage.
Early redemption charges
If you want to leave your deal early many lenders will penalise you. You’ll also trigger a penalty if you pay off your mortgage entirely and, sometimes, if you try to overpay. The penalty can by calculated in a variety of ways:
- A percentage of the original loan
- A percentage of the balance still owed
- A percentage of the amount you’ve already paid
- A number of months’ interest
- A fixed fee
This is an important charge to check. Many lenders charge a fee to close a mortgage when you’ve paid it off. Despite brokers estimating that it costs lenders around £50 to close off a mortgage this fee has soared recently with some mortgages carrying a £200 fee. The regulator has stated that lenders must not profit from this fee but are yet to act against lenders who are charging large amounts. So make sure you check what you’ll pay before you accept a mortgage offer. It may be masquerading under another name too so look out for a deeds fee; discharge fee; redemption fee; sealing fee; or vacating fee.