MSE’s Academy of Money
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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 each time.

Watch Video 2 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.

Download this video clip.Video player: Video 2 Understanding mortgages
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Transcript: Video 2 Understanding mortgages

NARRATOR
In this video, we explore the most popular different types of mortgage products on the market, focusing on the way that their interest rates are set. Understanding this is important, as the interest rate on your mortgage is a big factor in 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 remains unchanged during the term of the fixed rate, regardless of any changes in 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 with their budgeting, as the repayment won’t change throughout the mortgage. But whilst fixed rate mortgages provide certainty to borrowers, they do have a couple of downsides. If bank rate falls during the fixed rate term, those on fixed mortgages will not benefit from a lower mortgage rate: although fixed rates will also protect you from higher mortgage rates if bank rate rises.
In addition, fixed rate mortgages usually come with early repayment charges, which you’ll need to pay if you want to repay the mortgage early. This includes if you want to move to a new deal.
The other key issue is what happens when the fixed rate term comes to an end. At this point, the rate typically reverts to the lender Standard Variable Rate, or SVR, which may be much higher than the fixed rate that is terminated. This reversion rate risk is one fixed rate borrowers need to be alive to. We’ll look at SVRs in more detail next, as we move on to examine variable rate mortgages.
There are three main types of variable rate mortgages: trackers, discount mortgages, and standard variable rate mortgages. Let’s look at the Standard Variable Rate mortgage, often abbreviated to an SVR mortgage. You usually won’t opt for these mortgages when choosing a product, but it’s the type of mortgage you end up on when other mortgage deals come to an end.
The SVR is set at the discretion of the lender. It will move up and down periodically, usually when the Bank of England moves the main bank rate up or down. Note that 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 a lender’s SVR could rise by 0.35%. When you’re looking for a mortgage, the main variable rate product you’ll see is known as a tracker. 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. Trackers tend to have initial deals lasting for two to five years, though you can get lifetime trackers. Tracker mortgages don’t have early repayment fees, so you can usually switch to a new deal without waiting for your initial tracker deal to end.
Also in the variable rate mortgage stable are what’s known as discount mortgages. These deals usually offer a discount off a lender’s standard variable rate. This means that if the lender raises its SVR, you will pay more each month.
Again, these deals are usually over a short period of time: for example, two to three years, though longer deals are available. Unlike trackers, though, discount mortgages do tend to have early repayment fees if you want to repay your mortgage while you’re still in the initial discount period.
However, know what you’re getting into here, as it can be confusing. If it says a 1.5% discount, make sure you know what that means. Is 1.5% the rate you’ll pay, or is the 1.5% the discount you get off the lender’s SVR? Check carefully.
Variable rate mortgage products tend to be good when bank rate is falling or low and stable. 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.
However, the more you’re in need of certainty over what you pay, the more you should think about going for a fixed rate mortgage. 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, tracker mortgages, and SVR discount.
End transcript: Video 2 Understanding mortgages
Video 2 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 (though this is true of trackers and discount mortgages too). 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’ and ‘discount mortgages’)?

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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, there are normally no early repayment 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.

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