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Understanding mortgages
Understanding mortgages

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1.3 Fixed-rate or variable rate?

It is now time to make the decision about your mortgage – should you go for a fixed-rate or a variable rate mortgage product? Over the typical 25-year life of a mortgage this is a decision you may choose to make several times, switching from fixed-rate to variable or vice versa as you seek out the product that is best for you.

Watch Video 1 and explore the different interest rate features of mortgages, the fees that are associated with them and the pros and cons of different products. You will see that variable rate products take a number of slightly different forms.

Once you have watched the video, there are a couple of questions for you to answer below.

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Transcript: Video 1 Understanding mortgages

NARRATOR
In this video, we explore the most popular types of mortgage products on the market, focusing on the way the interest rates are set. Understanding this is important, as the interest rate on your mortgage will determine how much you have to repay each month.
First, let’s look at fixed rate mortgages. As the term indicates, the mortgage rate on these products remain unchanged during the term of the fixed rate, regardless of any changes in the interest rate, such as the Bank of England Bank Rate. Such products commonly have a term of two to five years. Although, longer terms, like 10-year mortgages, are sometimes available. Fixed rate deals are popular with borrowers who need certainty about their mortgage costs to help them with their budgeting.
But whilst fixed rate mortgages provide certainty to borrowers, they do have some potential downsides. If Bank Rate falls during the fixed rate term, those on fixed mortgages would not benefit with a lower mortgage rate. Although, clearly, if Bank Rate rises, fixed rate customers do not see their mortgage rate rise. In addition, fixed rate mortgages usually come with arrangement fees, and early repayment charges apply too.
The other key issue is what happens when fixed rate term comes to an end. At this point, the rate typically reverts to the lender’s SVR, which may be much higher than the fixed rate that has terminated. This reversion rate risk is one fixed rate borrowers need to be alive to.
So let’s look at variable rate mortgages. There are a number of different types. One type is a Standard Variable Rate mortgage, often abbreviated to an SVR mortgage. Here, the mortgage rate is set at the discretion of the lender. It will move up and down periodically, usually when the Bank of England moves its interest rate, known as Bank Rate. Mortgage lenders are not obliged to follow moves in Bank Rate, either in timing or in scale, when setting their SVRs. For example, Bank Rate could rise by 0.25%, and the lender’s SVR could rise by 0.35%.
The other main variable rate product is known as a tracker. Trackers have become very popular in recent years. Here, the mortgage rate is contractually linked to a major interest rate, usually the Bank of England’s Bank Rate. For example, the Tracker Rate could be Bank Rate plus 1%. So when Bank Rate moves up and down, then so does the Tracker Rate by the same amount.
Variable rate mortgage products, be they SVRs or trackers, are good for borrowers when Bank Rate is falling. By contrast, they are not good for borrowers when Bank Rate rises, since the mortgage rate will rise, thereby increasing the monthly cost of the mortgage to the borrower.
So there’s plenty to think about when choosing a mortgage product and, specifically, its interest rate characteristics. Let’s finish with a summary of the key features of fixed, SVR, and tracker mortgages.
End transcript: Video 1 Understanding mortgages
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Video 1 Understanding mortgages
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Activity 3 Fixed-rate mortgages: benefits and risks

Timing: Allow approximately 5 minutes

What are the pros and cons of fixed-rate mortgages?

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Discussion

Fixed-rate mortgages provide certainty about your monthly mortgage payments as these will not rise during the fixed-rate term. They are a sensible choice for households on tight budgets with only a limited capacity to afford an increase in the costs of a mortgage, or for those who simply prefer certainty about what their mortgage will cost.

Note that these fixed-rate products are commonly for 2 to 5 year terms, with a limited market for 10 year fixed-rate terms. Fixed-rate terms for longer periods have never caught on in the UK. So the likelihood is that any fixed-rate deal will only cover the first part of your mortgage term, and not the full term, unless you’re in the final years of a mortgage and remortgaging for the last time.

Fixed-rate mortgages often come with the cost of an upfront ‘arrangement’ fee. Those on fixed-rate mortgages do not benefit from falling interest rates. Also, usually you will have to pay an early repayment charge if you repay the mortgage before the end of its fixed-rate term. At the end of the fixed-rate term the mortgage will normally revert to the lender’s standard variable rate unless action is taken to move to an alternative mortgage product.

What are the pros and cons of variable rate mortgages (including ‘trackers’)?

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Discussion

Variable rate mortgages will move up or down as interest rates in the economy alter – specifically when the Bank of England moves its ‘Bank Rate’. Those with these mortgages benefit when interest rates fall and lose out when rates rise. This lack of certainty can cause problems with household budgets. On the other hand, arrangement fees are less common and there are normally no prepayment fees if you repay your mortgage early.

OK, it’s time for a short quiz to check how much you have learned so far. The section after that will look at the other options which may be available to you to customise your mortgage product.