3.3 Choosing a suitable mortgage
In the next activity, you’ll use the information about different types of mortgages to help a case study, Meiling, choose a suitable mortgage.
Activity 7 Advantages and disadvantages of different mortgage types
Meiling, a university lecturer, has been renting a flat in the city centre but decides to buy a house further out. She has lived quite frugally and managed to save a deposit for this, her first home. Buying the home will use all her cash savings. Interest rates are at a historic low and Meiling expects to continue in her present job for some years to come and to receive annual increments or increases in her salary as well as possible promotion.
For each of the following mortgage types, consider the plus points and potential risks and jot down a brief comment on its suitability for Meiling’s situation.
- a.Flexible mortgage
- b.Offset mortgage
- c.Fixed-rate mortgage
- d.Capped-rate mortgage
- e.Discounted mortgage
- f.Interest-only mortgage
- a.Flexible mortgage: this would allow Meiling breaks in payments if needed – this could be useful, given that for now she will have little or no savings to fall back on in an emergency. This type of mortgage also gives her the opportunity to overpay, for example, as her salary rises, which would reduce the mortgage term and overall cost. However, the variable rate is likely to be a bit higher than the lender’s standard variable rate and, if interest rates rise, her monthly payments will go up.
- b.Offset mortgage: All of Meiling’s savings will be spent on the deposit, though she could offset a current account against her mortgage. But, unless the average balance in her current account is relatively high (which seems unlikely), this type of mortgage is likely to be more costly for her than the other options.
- c.Fixed-rate mortgage: This would let Meiling manage her day-to-day money with certainty, which is good if her current budget is tight. However, she should be prepared for a rise in payments when the fixed term comes to an end if interest rates have then risen. If interest rates were to fall during the term, she could find herself paying more than she needs and having to pay a penalty if she wants to get out of the fixed-rate deal early - in making that judgement, Meiling might consider whether or not rates are already low, and the economic outlook.
- d.Capped-rate mortgage: This could be good as long as the cap is not too high. The cap would protect Meiling from significant rises in variable rates, yet she would also benefit if interest rates were to fall further. However, some capped-rate mortgages also have a ‘collar’, in other words a minimum below which the interest will not fall even if competing rates go lower.
- e.Discounted mortgage: This would be useful if her budget is currently tight, but the rate could rise during the discount period. She needs to be prepared for the extra cost once the discounted rate period ends if she stays with her current lender. Alternatively, she could plan to shop around and switch to a new discounted (or, say, fixed-rate) deal when the discount period ends, but if interest rates generally have risen then, she will still find her monthly payments rise and must be prepared for this possibility. If her salary rises as she expects, she should be able to cope.
- f.Interest-only mortgage: This would likely have lower monthly payments, but Meiling would have to think how to pay off the loan at the end of its term. She is buying a home to live in (not, for example, to rent out), so selling the property to pay back the loan is unlikely to be an option as she will still need somewhere to live. She could pay into a savings plan to build up the repayment sum, but this would push up her monthly payments considerably. Depending on the type of savings or investments, it also could expose her to the risk of a shortfall if her money does not grow as well as she hopes. In practice, in the UK, regulation generally prevents providers offering interest-only mortgages unless the borrower has a clear plan for repayment.