Understanding mortgages
Understanding mortgages

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Understanding mortgages

4.2 Ditching a fixed-rate mortgage

One trigger for remortgaging that arises under certain interest rate conditions is when making an early repayment of an existing fixed-rate deal and moving to a new mortgage makes financial sense.

Now look at repaying a fixed-rate mortgage early.

The calculations required to make good decisions are not daunting. Basically, you need to work out the costs of getting out of your current mortgage deal – there may be none if you are on a variable rate or tracker product. Add on the costs of a new deal (possibly an arrangement fee and perhaps legal costs, although the new lender will sometimes cover these). Then compare these costs with the savings you expect to make by moving to a new product with a lower mortgage rate than you are currently on.

In a period of falling interest rates, prepaying a fixed-rate mortgage and moving to one with a lower rate can make sound financial sense.

Here is an example:

The Sharp family have 3 years left on a 5-year fixed-rate (interest-only) mortgage of £100,000.

The current mortgage rate is 6% per annum but they could move to a new 3-year fixed-rate mortgage at 4% per annum. To do this they have to pay an early repayment charge of 6 months’ interest and also pay an arrangement fee of £500 for the new mortgage.

What should the Sharps do?

The costs of moving to the new product are:

  • The early repayment charge: 3% × £100,000 = £3000. (3% is 6 months of interest when the annual rate is 6%)
  • The arrangement fee: £500
  • Total £3500

But the benefits are the interest savings of 2% (that is, 6% less 4%) for three years:

That saves the Sharps £100,000 × 2% x 3 years = £6000.

So, the net saving is £2500.

The Sharps will have to dip into their savings to pay those upfront costs. But even if they are earning 4% per annum on their savings, the loss of interest earnings over the three years is only £3500 × 4% × 3 = £420

So, the Sharps should move to the new fixed-rate deal.

Activity 5 Does ditching this fixed-rate mortgage make sense?

Timing: Allow approximately 10 minutes

Try the maths of moving to a new fixed-rate deal.

This time the existing fixed rate is running at 4% per annum and has two years left.

The interest-only mortgage is for £100,000.

A new 2-year fixed-rate mortgage can be secured at 2% per annum.

The arrangement fee is £750 and the prepayment fee is 3 months interest.

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Discussion

The costs of moving to the new product are:

  • The prepayment fee: 1% × £100,000 = £1000 (1% is 3 months of interest when the annual rate is 4%)
  • The arrangement fee: £750
  • Total: £1750

But the benefits are the interest savings of 2% (that is, 4% less 2%) for two years.

That saves £100,000 × 2% x 2 years = £4000.

So the net saving is £2250.

The costs have to be upfront out of savings (assuming these are available), but even if these are earning 2% per annum, the loss of interest earnings over the two years is only £1750 × 2% × 2 = £70.

For these reasons, it would make sense to move to the new fixed-rate deal.

If you struggled with the maths, you can access the link at the end of the course to guide you on whether it makes financial sense to pay off your fixed-rate deal.

The next section looks at how you have to cover several different costs when buying a property. Your financial outgoings will certainly start, even before that first mortgage repayment.

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