Mortgage types explained

The term mortgage is derived from the old French/Latin term mort gage, meaning death pledge. Mort comes from the Latin word mortuus (dead). It is also where we got the words mortuary, mortal, and post-mortem from. The word gage, meaning pledge, was specifically used by knights pledging themselves in battle. It later came to represent a glove or armoured gauntlet that would be thrown down to challenge someone to a duel. If that opposing person picked up the glove, it signalled that they were pledging or engaging in the duel.

So, what does dead pledge mean? The name suggests that a person will be paying it until they die. However, it actually means that the pledge dies when all payments have been made, meaning the property is now yours. Or, the pledge dies if you do not make the payments, and your home will be taken back as collateral. Mortgages date back to the 12th century but did not become a realistic option until the 19th century.

In the early 19th century, almost everyone rented, and landlords took full advantage of this with excessive rent prices. The first and second World Wars allowed more people to own their houses, as homes were specifically built for returning soldiers. In the 1950s and 60s economic prosperity allowed Brits to buy homes affordably, using a mortgage. In the 1980s, the government introduced a Right to Buy scheme allowing people to buy their council houses. This saw a huge growth in home ownership.

In recent years mortgages have become the new normal, with it being the only way for most people to become property owners. For example, in England alone in 2020, 6.8 million properties were owned using a mortgage. However, not all mortgages are the same. This article will talk you through the different types of mortgages.

What are fixed-rate mortgages?

Fixed-rate mortgages are the most common type of mortgage for homebuyers. In short, a fixed rate mortgage is an agreement that freezes (fixed) the amount (rate) of interest you pay on your mortgage deal. A fixed-rate mortgage will keep the same interest rate for a set period of time. This means you know exactly what your monthly payments will cost without having to calculate interest rates.

Fixed-rate mortgages are often seen as more secure. This is because no matter how high the Bank of England Base rate becomes, your rate will be set in stone. This is especially beneficial in the current climate. As Covid-related issues and energy shortages have spiked inflation, the interest rate has risen to bring it back down. This means that those on non-fixed rate mortgages have seen an increase in their monthly repayments.

However, it also means that if interest rates are lower than your fixed-rate mortgage agreement, you will miss out on savings. Fixed-rate mortgages remain fixed for a period of anywhere between one and 15 years. The lower and higher end of these is rare. Usually, the longer the fixed rate period, the higher the agreed interest rate will be set. After that, you can re-mortgage, or you will be placed on the standard variable rate of your lender.

What is a capped-rate mortgage?

Capped-rate mortgages are variable-rate mortgages with an added benefit. The interest that you pay matches the lender’s standard variable rate. However, the interest rates of this type of mortgage are capped. This means that even if the lender’s standard variable rate increases because the base rate of the Bank of England has increased, it can only be raised by a certain level.

For example, if your mortgage has an interest rate cap of 5%, but the variable rate goes to 6%, you will only pay 5%. However, because of recent instability in the interest rate, many lenders do not offer a cap anymore.

What are tracker mortgages?

Tracker mortgages are also among the most popular types of mortgages. These are a type of variable rate mortgage. Tracker mortgages go up and down with the Bank of England’s base rate. So, they track the interest rate of the Bank of England, rising and falling to match it. There is also an added, agreed-upon interest rate as well. For example, if the base rate is 2% and the agreed interest rate is 2%, you will pay interest amounting to 4%.

Some modern tracker mortgages have a collar that eliminates any savings gained when the base rate falls. This means that there is a set rate that monthly payments cannot drop below no matter how low the base rate is. For example, if the base rate drops to zero and the collar is 0.5%, you will pay 0.5% interest instead of nothing.

The tracker rate will be in place for a set period of time, typically around two years. After this, you will be switched to the standard variable rate SVR unless you remortgage.

What are discount mortgages?

Discount mortgages are another variation of the variable rate mortgage. This type of mortgage works around the standard variable rate SVR, as set by the lender. It charges interest at this variable rate but includes a discount.

So, for example, if the standard variable rate SVR is 4% and your agreed discount is 2% would only pay 2% interest on monthly payments. If the variable rate increases, so will your monthly repayments. If variable interest rates fall, your monthly repayments will be reduced.

Again, the discount will only be applied for a fixed period – usually two years. After the period ends, you will have to pay the full variable rate.

What are standard variable rate mortgages?

A standard variable rate mortgage has an interest rate that is subjectively set by the mortgage provider. A variable rate mortgage is usually the most expensive type of mortgage. This is because there are no discounts or freezes applied. Usually, the interest rate is set at a higher margin than the base interest rate. However, even if the base rate goes up, the variable rate will normally go up anyway. This, in turn, means you pay more for monthly repayments.

What is an interest-only mortgage?

As well as repayment mortgages such as the ones previously mentioned, where the loan amount is gradually repaid each month, there are also interest-only mortgages. In essence, you do not make mortgage repayments each month, and instead, you only pay interest.

Providers of interest-only mortgages will then try and recoup the full amount of the loan when the mortgage term has ended. If you take out this kind of mortgage, you must save money each month so that you can repay the debt at the end of the term. Otherwise, you risk losing your home. Typically a lender will need evidence you can repay the debt, which is known as a repayment vehicle. This is usually an ISA, endowment policy, or investment.

However, you are unlikely to be granted an interest-only mortgage these days. This is because an interest-only mortgage is a high-risk loan – as shown by the 2008 financial crisis. When this crisis happened, it emerged that hundreds of thousands of people would struggle to pay off their interest-only loans.

What are 95% mortgages?

This type of mortgage was introduced to help people make it onto the property ladder. In 2022 house prices soared to extreme levels. For example, the average house price in England is now around £295,888. According to Statista, the UK average wage is 31,285. This means that the average house price in England is almost 10x the amount of the average yearly wage in the UK.

For some people, especially first-time buyers, a large deposit is just not possible. In April 2021, a 95% government-backed mortgage scheme was introduced. This meant that people only had to put down a 5% deposit to get a mortgage. So for the average house in England, someone would only need to put down £14,794 instead of nearly 30 grand for a 10% deposit. However, some limit the amount you can borrow to £250,000.

Although this helps people who cannot afford high deposits to get a mortgage, it also means they will pay higher interest rates and higher lending charges. So, ultimately those with less still pay more, and the lender still wins. For this reason, it is still recommended that you put down a higher deposit if possible.

How do I get the best mortgage deal?

For some people, the different types of mortgages are meaningless. This is because their financial circumstances will limit the types of mortgage deals they can get. For example, someone with bad credit may be limited to costlier variable rate mortgages instead of fixed rate or tracker mortgages. So how do you improve your chances of getting the mortgage deal that you want?

Firstly, you should build your credit score so that you represent less risk to the lender. A quick way to do this is to make sure you are on the electoral roll and to pay off any outstanding debt. As previously stated, putting down a larger deposit will bring interest rates down. So, although a 95% mortgage is alluring, it may be worth waiting and saving so you don’t pay more in the long run.

You should also shop around for the best offer. Make sure that in your excitement to become a homeowner, you don’t accept the first offer that comes your way. You can even use your first offer to negotiate with a competing lender. Interest rates are not the only thing to look out for; you should also look at what fees the lender charges. For example, there may be an early repayment charge or an overpayment fee that charges you for paying out your mortgage early.

Different types of mortgage: Summary

Mortgages in some form have been around since the 12th century. However, it wasn’t until the 19th century that they became commonplace. There are many different types of mortgages to choose from if your credit rating and financial health afford you the luxury of choice.

Fixed-rate mortgages freeze the interest rate of mortgage repayments for a set period of time. A capped-rate mortgage caps the amount a lender can charge in interest. A tracker mortgage charges interest based on the Bank of England’s base rate and an additional agreed-upon charge.

Discount mortgages give you a discount on the lender’s variable interest charge for an agreed-upon time. Usually, this is a short period of time, such as two years. A standard variable rate mortgage charges interest based on the lender’s own variable rate. This often costs more than other types, and the rate is subjectively set by the lender.

Interest-only mortgages only charge you for interest and not for mortgage payments. This means at the end of the mortgage period, the full loan amount is due. These are hard to come by now as they are deemed high-risk.

A 95% mortgage is a mortgage that only requires a 5% deposit. However, this often means you pay higher interest rates.