Mortgage types explained
Applying for a mortgage first involves making quite a few choices and decisions.
At a basic level all mortgages work in the same way. You borrow a lump sum of money over an agreed term and the lender charges you interest on the amount you owe.
The monthly repayments will be affected by:
- The size of the mortgage
- Repayment method
- Mortgage term
- The interest rate
Which repayment method?
The first big decision for any mortgage is “How are you going to pay it back?”
This is normally a straightforward decision between a repayment or interest-only mortgage as these are the two options offered by lenders.
With the first you make monthly repayments comprising of both interest and capital. With the second you only pay the interest on the money you’ve borrowed.
Let’s see how they both work.
REPAYMENT mortgage
With a repayment, or capital & interest, mortgage you slowly repay the amount borrowed (the capital) plus the interest over the mortgage term.
Each month you pay interest and some of the capital off, so the amount you owe gradually reduces.
How do they work?
The repayment of your mortgage is calculated over the term you have chosen (ie 25 years).
The lender works out how much interest and how much capital you need to pay to keep to the agreed term and this is combined into one monthly payment. At the start you won’t be paying much capital off but after a few years this changes so that more of the monthly payment goes towards paying back the debt.
Your monthly repayment won’t change though, unless the interest rate changes. It’s the proportion of your payment that alters over the years.
So as you can see in the chart below, each year of the mortgage term passes your outstanding mortgage amount gradually reduces. The idea is that with the very last mortgage payment your debt is completely settled.
Repayment mortgages are the go-to choice for the majority of people applying for residential mortgages. (Property investors generally prefer interest only).
The monthly cost is obviously quite a bit higher than an interest only mortgage but you always know that your mortgage will be fully repaid. To make the payments more affordable, many borrowers will choose a marathon mortgage, where the term is 35 or even 40 years.
The table below shows the different monthly payments for the same initial mortgage.
| £200,000 borrowed over 25 years at 3.50% | |
|---|---|
| REPAYMENT METHOD | MONTHLY PAYMENT |
| Interest only | £584 |
| Repayment | £1002 |
Advantages and disadvantages of repayment
ADVANTAGES
The biggest advantage is that your mortgage is being paid back, month by month and your annual mortgage statement will show the balance decreasing.
DISADVANTAGES
The primary disadvantage is that the monthly payments are quite a bit higher than an interest only mortgage.
INTEREST ONLY mortgage
With an interest-only mortgage the lender is only expecting you to pay the interest amount each month.
The monthly payments are therefore cheaper than the equivalent repayment mortgage. The downside is that the debt does not reduce, so at the end of the term the lender will be asking for all of the money to be repaid.
How do they work?
With an interest only mortgage you do not have to make any repayments of capital with the monthly payment. The lender is only expecting you to pay the interest, not any of the original debt.
So as each year of the mortgage term passes your mortgage balance stays the same.
Most bridging loans and buy to let mortgages are set up as interest only.
The chart below shows how the mortgage balance changes each year.
One of the biggest benefits is that the monthly payments are considerably lower than an alternative capital & interest mortgage. This makes them much more affordable.
The table below shows the different monthly payments for the same initial mortgage.
| £200,000 borrowed over 25 years at 3.50% | |
|---|---|
| REPAYMENT METHOD | MONTHLY PAYMENT |
| Interest only | £584 |
| Repayment | £1002 |
How do you repay an interest only mortgage?
For most residential mortgages the lender is looking for a structured plan of how this will be achieved. They will be more relaxed for buy to let mortgages and bridging loans.
Many years ago endowment mortgages were popular, which paired an interest only mortgage with an endowment savings plan. It is no longer possible to take out an endowment plan for a mortgage.
There’s no set way that an interest only mortgage must eventually be repaid. Each lender has their own rules on whether your suggestion will be suitable.
Additionally, it would be possible for you to repay lump sums on an ad-hoc basis as and when funds allow. This would also reduce your ongoing interest payments as the debt is reduced. Don’t forget to check regarding repayment penalties or ERC’s.
Some options would be:
- Sale of the property (downsize)
- Sale of another property
- Equity release
- Investments
- Savings plans
When applying for an interest only mortgage for your main residence the lender will want to ensure there is a solid & plausible plan for eventual repayment.
If the mortgage term takes you beyond age 65, your application will require details of your pensions as you will be borrowing in to your retirement. Another option to consider further down the line is whether you can change your interest-only mortgage to repayment.
Advantages and disadvantages of interest only
ADVANTAGES
They are considerably cheaper than a repayment mortgage. Most landlords choose to have interest only buy to let mortgages as their income yield is greater. If you currently have a repayment mortgage then it may be possible to change your mortgage type over to interest only.
DISADVANTAGES
The primary disadvantage is that over the whole mortgage term you will pay more in interest than the equivalent repayment mortgage. You also need to be quite disciplined to keep putting money aside for the final repayment.
And now for some magic!
PART & PART mortgages
There is actually one more way for a mortgage to be setup. The third, and little known method, is the ‘part and part mortgage’.
The vast majority of mortgages are repayment with some set up as interest-only. But there is a third method called a “part-and-part” mortgage. This is not widely promoted but most lenders should support it, ask your mortgage broker for their guidance.
What is a Part Repayment, Part Interest Only Mortgage?
With a part and part mortgage you will be splitting the repayment of your debt between repayment (capital & interest) and interest only.
REPAYMENT + INTEREST ONLY = PART & PART
With the repayment portion the debt will gradually reduce as normal but the interest only part stays the same. When the mortgage ends, there will still be a debt to pay off.
Part and part mortgages are a hybrid of repayment mortgages and interest only mortgages.
How does a part and part mortgage work?
When applying for a mortgage you will ask the lender to split the loan into 2 parts:
The repayment part
The interest only part
There’s no definitive way to how these are set up or proportioned. It will be down to what suits you best, along with the lender’s agreement, ask your broker to help.
It’s fair to say that most lenders would prefer the majority of the loan to be on a repayment basis.
The chart below shows how the mortgage balance changes each year.
Repaying the interest-only part
As with any interest-only mortgage you need to consider how it will be repaid.
The lenders will want quite a few details about your plan so that you are not committing to a mortgage that you will be unable to pay back when the term ends.
Who would want a part & part mortgage?
It’s fair to say that this setup is not for everyone. But it is very flexible and can suit different people for different reasons.
There’s two main reasons why you might want one:
- You want your mortgage to be a little cheaper each month but still with some of the capital reducing
- You want flexibility for a portion of the loan as you know that lump sum funds will be available within the mortgage term. These could be bonuses, share sale, pension payouts, inheritance etc
How do part repayment and part interest only mortgages work?
Repayment Methods – SUMMARY
So to summarise there are three ways that a mortgage can be setup:
REPAYMENT
The simplest and most common choice. You pay a little off of the mortgage each month and at the end it’s fully repaid.
INTEREST ONLY
You don’t pay any of the mortgage amount back monthly. You could make ad-hoc payments or wait to pay it all at the end.
PART & PART
A mixture of the other two. Your independent mortgage adviser will be able to explain how this could work for.
INTEREST RATES
Once the repayment method is sorted it’s time to look at the different interest rate options.
The interest rate is the percentage of your mortgage balance that the lender charges you each year. This is how the lender makes their money. There are several different types of interest rate products that lenders offer.
Standard variable
A standard variable rate (SVR) mortgage is a type of mortgage where the lender’s interest rate can move up or down. If you have a variable rate mortgage and the interest rate changes your lender will recalculate your monthly payments based on their new SVR.
Discount variable
With a discounted rate mortgage your interest rate is variable and will be based on the lenders SVR less a discount percentage. For example: SVR minus 0.25% pa. These products generally last for a set period of time before reverting to the SVR.
Tracker rate
With a tracker rate mortgage the interest rate that you will pay is directly linked to a Bank interest rate, this is often the Bank of England base rate (BEBR).
Lenders usually add a percentage rate, or margin to the base rate.This means that your tracker interest rate will be whatever the Bank of England Base Rate (BEBR) is plus a margin of 0.85%.
Tracker rates are variable, this means that when the BEBR rises or falls your monthly payments will change.
Fixed rate
With a fixed rate mortgage the interest rate is fixed at the same rate for a set period of time. The time period offered could be from one year to ten years and the interest rate will differ according to the number of years chosen.
Fixed rates make monthly budgeting much easier as your repayments don’t change. Your fixed interest rate is unaffected by changes to other interest rates, so whether they go up or down, your monthly repayments will stay the same.
When deciding on the interest rates available it’s important to look at the rate, the product term and also the early repayment charges (erc).
- The rate is the mortgage interest rate
- The product term is how long the special interest rate will last
- The ERC is the penalty for repaying earlier than agreed
Offset Mortgages
Offset mortgages are not as common as they probably should be.
They are a mortgage which is linked to a savings and/or current account. The credit balances are ‘offset’ against the mortgage debt. The interest is calculated daily and only charged on the difference, while also paying off the capital.
Instead of earning interest on your savings, you will pay mortgage interest on the mortgage balance less the amount of savings you have. This means that you pay less interest on your mortgage.
Sometimes referred to as a current account mortgage.
Our Offset Mortgage Guide explains this innovative product in more detail and it’s also possible to get a family offset mortgage.
They are particularly tax efficient for higher rate taxpayers.
The mortgage term
As well as being able to choose the repayment method and interest rate, you also have a decision to make about the mortgage term.
The mortgage term is the number of years your loan is set up for.
If, like most people, you choose a repayment mortgage then the term has a direct effect on what you pay each month. Shorten the term and your payments go up, lengthen the term and payments go down.
The standard term for many decades used to be 25 years. Now it is more common for borrowers to opt for a 30-35 year term, to help with affordability.
Here’s some additional reading:
GUIDES
Some more guides that you may find useful
We have lots of different guides which will help you on your mortgage journey.
There’s also a jargon busting knowledge base and useful articles.
Buying a house for the first time can be daunting, our guide runs through the basics to help you understand how it all works.
Moving home isn’t something we do very often This guide runs through the basics and provides a reminder of what’s involved.
How much would a £250,000 mortgage cost each month? What about the repayments for £750,000 or even more?
How many types are there? What is a mortgage valuation and do you always need to pay extra for a full survey?
IN SUMMARY
The number of mortgage deals available to you will mainly depend on your deposit. The higher your deposit, or equity is, the better the deals are.
They are lower risk loans for the lender so they are happy to offer lower rates.
When comparing mortgages don’t just take the interest rate offered. There are other mortgage fees, costs or even incentives that have to be put ‘in the mix’.
An independent mortgage broker will be able to do all of this work for you. From searching for suitable mortgages to calculating which one is financially the best.
FAQ
Frequently Asked Questions
What does LTV mean?
LTV is loan to value. It is the ratio, expressed as a percentage, of your mortgage when compared to the property value. Check out our LTV calculator.
Do you have an online calculator?
Yes we have many helpful online mortgage calculators to help people work out the cost of a mortgage and moving home.
How do I get the best deal?
By using an independent mortgage broker you will have access to thousands of different schemes and rates.
Is it worth paying for a mortgage broker?
In most cases, yes. A broker is a mortgage expert. So they can quickly find the best deal from all of those available, saving you time and money.
Would I save money with an offset mortgage?
An offset mortgage provides an extra benefit if you have surplus income or savings which can be ‘offset’ against the mortgage debt. Our Offset Mortgage Guide provides a fuller explanation.
Why would anyone be on the SVR?
This is a valid question. Many people simply don’t know as they have not looked into what their mortgage costs. Some people will be on the SVR while they are waiting for a: remortgage, capital repayment, house move etc.
Who offers thatched property mortgages?
Thatched properties would need a specialist property mortgage due to the type of roof and walls. These are available from brokers, read more about thatched property mortgages.
How much do you need to earn for a £750K mortgage?
There’s no simple answer to How much do you need to earn for a £750,000 mortgage? But these mortgage affordability guides might help.
