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Interest options

When you take out a mortgage, as well as repaying the amount you've borrowed, you'll also have to pay interest on the loan. There are several different ways of repaying the interest - this page looks at your options.

The Which? Mortgage Guide has more information on the pros and cons of different kinds of mortgage.

Comparing interest rates

Before you can compare interest rates, you need to know what the following terms mean:

  • Bank base rate (BBR) - this is the rate of interest set by the Bank of England. If you hear on the news that interest rates have gone up or down, they will usually be referring to the bank base rate.
  • Standard variable rate (SVR) - this is the standard rate of interest that the lender charges. This usually goes up and down in line with any change in the bank base rate.
  • Annual percentage rate (APR) - this is the annual percentage rate of interest charged by the lender. It is higher than the SVR because it includes one-off charges like arrangement and valuation fees. If a mortgage starts with a fixed rate of interest that will change to the SVR after a specified number of years, the lender must include this in the APR calculation. This means that the APR should give a more accurate picture of how one mortgage compares with another. The APR should always be shown clearly on any information that you are given about a mortgage.

Variable rate mortgages

If you have a variable rate mortgage, your payments will go up and down according to the rise and fall of bank interest rates.

There are several kinds of variable rate mortgages:

  • Standard rate mortgages where you will be charged interest at your lender's rate.
  • Discounted rate mortgages where, for a fixed period of time, you will be charged an interest rate that is lower than your lender's SVR but which will rise or fall in line with the SVR. Once the discount period is over, you will probably be charged the SVR.
  • Base rate tracker mortgages where the rate of interest you are charged will be set at a fixed percentage above the Bank of England base rate (if you have a Charges Access and Terms (CAT) mortgage, this can be no more than two per cent above), and will follow the rise and fall of the base rate. Some base rate tracker mortgages may offer an initial discounted rate, with interest set below the BBR.

If the rate is discounted for the first few years, the stated APR must take into account the higher interest rate for the rest of the term.

If you are considering taking out a variable rate mortgage you must be confident that you will be able to afford higher mortgage payments if interest rates rise.

Fixed rate mortgages

These guarantee that the interest rate on the loan won't change for a set period - usually, between two and five years. This means you don't have to worry about increased payments in the first few years if interest rates go up. But if the lender's standard rate falls below your fixed rate, you will lose out.

You may be able to get a deal where you borrow part of your mortgage at the variable rate and part at a fixed rate, protecting you to some extent whether interest rates go up or down in the future.

Capped rate mortgages

With a capped rate mortgage, the interest rate is guaranteed not to go above a certain level during the capped period, often between three and five years. A capped and collared mortgage sets a minimum as well as a maximum interest rate for this period. Capped mortgages are good if you need to anticipate the maximum amount that you would have to pay if interest rates go up but still allow you to benefit if interest rates go down.

Flexible mortgages

There is no exact definition of a flexible mortgage. However, usually the outstanding balance of your loan (on which you pay interest) will be calculated daily rather than annually. This is a good thing, because it saves you interest in the long run. Some mortgage lenders also offer this feature on their traditional, standard rate mortgages, and it's one of the requirements of a CAT mortgage.

In addition, a flexible mortgage should offer you the freedom to repay the loan at the speed you choose. You may be able to:

  • increase or decrease your monthly payments
  • pay in lump sums
  • build up credit you can draw on
  • take a payment holiday where you pay nothing for a few months.

Flexible mortgages are good if, for example:

  • you receive bonuses at work that you can pay straight into your mortgage to help build up credit; or
  • you want to make a big change to your life, such as going to university, starting a family or travelling round the world, and you'd like to reduce your payments or even stop paying altogether for a while.

However, you're unlikely to get this flexibility and a very cheap interest rate.

Current account or offset mortgages

A current account (or all-in-one) mortgage combines a flexible mortgage with a current account in one package. Money in your current (or savings) account can be set against the amount you owe on your mortgage or other borrowing, so that your interest payments are reduced. Depending on your income and the amount of savings you have, this could save you quite a bit of money, as the interest charged on your mortgage is likely to be higher than the interest you gain on your current account or savings. It may mean you can pay your mortgage off sooner.

Cashback mortgages

Some lenders offer cashback deals where you get a percentage of the loan - say five per cent - as a cheque to spend on your move or whatever you choose. But you may prefer not to go for this unless you really need the money, as the deal may tie you to the standard rate of interest for a number of years.

Always read the small print!

A cheap rate or a flexible deal may have strings attached, so ask your adviser or check the small print in the lender's promotional materials. For example, the lender may require you to take out your house insurance or mortgage protection insurance through them. Or there may be a big redemption penalty (which could, for example, wipe out all the saving you made on a special deal) if you repay your loan early or switch to a better deal in the early years of your mortgage.

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The important points

  • There are several different ways you may be offered to pay interest on your loan (mortgage), bank base rate, standard variable rate and annual percentage rate.
  • A variable rate mortgage means your payments go up and down as bank interest rates change.
  • A fixed rate mortgage means you know the interest rate for a set period, between two and five years.
  • A current account mortgage allows money in your currrent or savings account to be set against the amount you still owe, so you only pay interest on the amount still owed above your account balance.

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