How to pick a mortgage scheme - summary

We have now discussed a wide variety of mortgage concepts.  While you are ultimately searching for the one mortgage product that offers the best financial value-for-money, as measured by the IRR, there are other factors affecting your final scheme choice that depends on personal circumstances and attitudes. 

From our earlier investigation, we now know when an interest-only mortgage is worthwhile, who would pick a fixed rate and who would pick a variable rate.  You recognise that your personal choice depends on your attitude to risk and your awareness of financial planning in general. 

So, by way of summary, here is a short question and answer session, which might help guide you to your personal, optimum scheme choice.  This “Mortgage Wizard” is also available as an included spreadsheet.

 

The preliminaries
Before answering the main questions, check out the following:

Buy or Rent?

Before deciding on a house purchase mortgage at all, be sure you are better off buying than renting.  If you are likely to move within two years, renting may turn out better value for money, depending on the growth of house prices.  See the “Buy or Let” spreadsheet to satisfy yourself.

Mortgage or Re-mortgage

Are you looking for a re-mortgage?  This is required if you are not moving house, but have an existing mortgage, and you wish to switch to a better deal with a new lender or even the same lender, often increasing the loan at the same time.  In this case, use the “Remortgage” spreadsheet to enter your current loan details to ascertain the cost of switching mortgage.

Credit History

Some lenders will not lend to you if you have an impaired credit history, such as a CCJ (County Court Judgement) or have arrears with other lenders.    Fortunately there are some lenders who specialise in lending to those with an impaired credit history.  If you have had any credit or arrears problems in the last 6 years, you will need to disclose this to your selected lender:  all lenders perform a credit check before lending, so they will find out anyway.  If they are not prepared to offer you a mortgage, seek out a specialist lender, if necessary, enlisting the help of a specialist mortgage adviser. 

Now please answer the following questions.  In each case, the reasoning behind the question is stated first.

Question 1 – Income & Job

In general, employed people enjoy a more stable income than self-employed people.  Those with less regular income might well be attracted to flexible payment features.  Those with stable income might prefer fixed rate loans or level flexible payment loans.  Those with increasing income might favour discounted rate schemes.

Which is correct?

11.  My income is fairly reliable and stable.

12.  My income varies and is not always predictable.

Write down the answer, either 11 or 12.

Question 2 – Attitude to Financial Management

Some people just want a simple, worry-free mortgage, whereas others might want to get that little bit extra out of their finances, using more sophisticated arrangements.

Which paragraph best describes you?

21. Low Awareness.  Not really interested in investment or financial planning matters.   Know very little about it.  Just want the simplest, best deal.

22. Medium Awareness.  Know a little bit about investment and try to keep my financial affairs organised.  Prepared to involve myself in my finances when I have the time.

23. High Awareness.  Very interested in investments and financial planning, and spend some time in ensuring my affairs are in the best possible order.

Write down 21 or 22 or 23.

Question 3 – Attitude to Financial Risk

Attitude to risk affects choice in a number of ways.  Conservative people might prefer fixed payments, minimum sized loans and capital repayment mortgages that finish as soon as possible. More adventurous people may prefer to take their chance with variable interest rates, maximum sized loans and interest-only loans repaid by ISAs, and flexible payments.  Some may go for a combination of factors.

Which paragraph best describes you?

31. Conservative.  Cautious.  Minimise risk wherever possible, even if it meant taking a lower return.  Would probably not buy shares directly.

32. Realistic.  Accept that occasional small risks are sometimes necessary to achieve better returns.  Might consider an ISA investment.

33. Adventurous.  Speculative on occasions.  Recognise that high rewards come from taking high risks, and is prepared to take such sensible risks.

Answer 31 or 32 or 33.

So now you should have written down three numbers, eg 11, 22, 32.  From the following table, write down the paragraphs that relate to your answers. Think of a comma as reading “and”, so “11, 21” means “answer 11 and answer 21”.

Answer                                                          Paragraph number

11 (stable income) and:

          21, 31 (low, conservative):            

           1a, 2a,

21, 32 (low, realistic):                       

 1a, 2a

21, 33 (low adventurous):                   

 1a, 2a or 2c(i) or (iii)

 

22, 31 (medium, conservative):                 

 1a, 2a   

22, 32 (medium, realistic):                       

 1a, 2c(i) or (iii), 3

22, 33 (medium, adventurous):                 

 1b, 2c(i) or (iii), 3

 

23, 31 (high, conservative):                   

 1a, 2a or 2b

23, 32 (high, realistic):                            

 1b, 2c(i) or (iii), 3

23, 33 (high, adventurous):                     

 1b, 2c(i) or (iii), 3

 

12 (variable income) and:

21, 31 (low, conservative):                    

1a, 2a

21, 32 (low, realistic):                         

1a, 2c(ii)

21, 33 (low adventurous):                  

1a, 2c(ii)

 

22, 31 (medium, conservative):         

1a, 2a 

22, 32 (medium, realistic):              

1a, 2c(ii), 3

22, 33 (medium, adventurous):      

1b, 2c(ii), 3

 

23, 31 (high, conservative):

1a, 2a or 2b

23, 32 (high, realistic):        

1b, 2c(ii), 3

23, 33 (high, adventurous):

1b, 2c(ii), 3

 

Write down your “results” paragraphs, eg 1a, 2c(i) or 2c(ii), 3, and then consult the relevant paragraphs below, which now summarise the scheme that should be particularly applicable to you.  You can also read those paragraphs that may not have applied to you, which may cause you to re-think your attitudes.  Please remember that this is only a suggested guide and is not meant to replace a full fact-finds of the type obtained by independent advisers.

Results Paragraphs

1.   Method of Repayment

a)  Capital repayment mortgage

Monthly repayments include both capital and interest to the lender so the loan is gradually repaid over the mortgage term:  the shorter the term, the higher the repayments. 

If you select a capital repayment mortgage, you might want only the lowest loan you need to make a purchase, with the shortest term you can afford, allowing some leeway for possible future interest rate increases.  In general, the planned mortgage term should finish before your planned retirement date.  In practise, many people move house every 5 to 7 years.  This means, for a repayment mortgage, you can easily re-jig the loan at every move.

b)  Interest-only

You pay interest only to the lender: the monthly payment is the same regardless of the mortgage term.  The capital debt is repaid at the end of the term with the proceeds of a separate investment plan, which is built up from regular payments. 

This method is only financially worthwhile if the overall return on the investment, after tax and charges, exceeds the overall interest rate charged on the mortgage.  This is unlikely to happen if you choose a conservative investment plan.  But it could be worthwhile if you invested sufficient monthly payments into tax-privileged funds linked to shares, such as ISAs.  Those with a conservative attitude to investment might be better off with a repayment mortgage.

Those selecting an interest-only mortgage might want the largest loan possible, and to keep it going as long as possible, up to retirement date. The longer the term, the lower the monthly investment needed and the better chance the investment has of outperforming the mortgage interest, which is the objective of the interest-only method. 

2.  Schemes

a)  Fixed rate

Some lenders will guarantee a fixed interest rate for an agreed period of time.  The main advantage is a stable payment schedule for that period, regardless of what happens to interest rates generally.  After the initial fixed rate period, the loan reverts to either a variable or a new fixed rate.

But lenders need to protect themselves should underlying interest rates move up, when they would lose out.  This protection costs money. So the overall value-for-money, compared with using a variable rate mortgage, might be higher, but you have bought peace of mind.  Should you terminate the mortgage early, there is normally a redemption fee payable, usually waived if the loan is continued with another property.

Fixed rates should not really be used to “out-guess” the market.  Lenders know more about the future of interest rates than the borrower:  they are therefore more likely to quote rates on which they will win, rather than lose – but you could be lucky.  Bargains are also occasionally available from old tranches, which were raised before new rate trends were established.

Many lenders also include a discount on a fixed rate loan as an incentive to make it more attractive.  This camouflages the real fixed rate component, which makes these schemes harder to compare. 

b)  Cap or Collar

Caps and Collars are in the same family as fixed rates.  A few lenders will cap an interest rate, so you know it cannot go higher than the specified rate, but it could change to a lower variable rate if interest rates fell generally.  As with fixed rates, this added peace of mind costs money, and a capped rate is usually higher than a fixed or collared rate:  an early redemption fee is payable, unless you take the loan with you if you move house.

A collar is similar to fixed rate range,  a rate which can move up or down within a preset maximum of a cap and a minimum floor – like a snake in a tunnel.  The narrower the range the lower the cap and the higher the floor, until they both ultimately approach the same value as a fixed rate.

If you are simply looking for stable payments, a straightforward fixed rate will provide that, without the need for capping or collaring.

c)  Variable rates

A standard variable interest rate will move up and down during the mortgage term, broadly in line with interest rates in the economy as a whole.  In the long run, lenders have to ensure that their lending rates cover the interest paid to their depositors and to cover expenses.  Standard variable rates usually work out at about 1% to 2% above bank rates in general: some lenders even guarantee a bank rate link, say 1% over bank rate.

Lenders also offer incentives, which can typically be cashbacks, discounted rates for an agreed period or a combination of both.  Some lenders will offer a lower variable rate throughout, with no initial incentives. 

Such initial incentives almost always come with early redemption fees, but most lenders waive these fees if you move house and continue with the same, or a higher mortgage.  The main types are: -

i)  Cashback

A tax-free lump sum payable at, or soon after completion:  ideal for those whose capital resources are stretched and who would welcome some extra cash for furniture or such like.  This scheme is also probably easier to manage than a discounted rate, given equal value-for-money, since the monthly payment is level thereafter subject to future rate changes.

ii)  Discount

A reduced interest rate for a specified number of years, sometimes in more than one step.  A lower payment for a year or so is useful for those whose income is stretched initially, but who expect improvements later on.  Be sure you do not get too used to the lower payment.  The initial discount period to select depends on when you think your income will improve.

iii) Lifetime “discount”

This is not really an initial incentive but a straightforward level payment loan: the interest remains as low as possible throughout the mortgage, often with a guaranteed margin over a specified base rate or a promise to beat other specified rates.  This scheme sometimes offers better long-term value than a cashback.  Since there is no initial discount, there is seldom a redemption fee, so you can settle up at any time.

3.  Flexible payment (including current account mortgages)

There are a growing number of schemes where you can choose your own payment schedule.  You can pay in, or take out random lump sums and can take occasional payment holidays, if there is a sufficient “reserve”, and there is normally no early redemption fee.

For those on variable incomes, such as the self-employed, this type of scheme may be particularly useful.  There is also the added attraction of D.I.Y. mortgage management, for those interested enough, by setting your own payment schedule.  For example, you can accelerate the termination of your mortgage by simply paying more each month: you might aim to increase your payment every year. 

You could also have a D.I.Y. “fixed” rate by paying as if you were on a fixed rate schedule, assuming it is at a higher rate that the prevailing normal variable rate.  But, unlike a real fixed rate, any such over-payment will repay a proportion of your mortgage.  Note that most flexible lenders do not offer a formal fixed interest rate option, as there is no need, and so most are variable rate.

Scheme Choice Summary

Hopefully you should now have a better understanding of which scheme and method of repayment matches what type of borrower.  Attitudes are important but features such as extra security and flexibility come with a higher price or less flexibility if an early redemption fee is included.  Having decided on the scheme, the measurement of which actual lender is simply down to a measurement of the lowest IRR, remembering that future interest rate projections can only be guesses.

Use the “Loan Comparator” spreadsheet for this purpose, or insist your adviser does, to sort out the true value of so-called incentives and the other costs of a mortgage.  If you are re-mortgaging, use the “Remortgage” spreadsheet to identify the cash value of a switch.

Finally, if you chose an interest-only mortgage, use the “Investment and Mortgage” spreadsheet to understand how the investment must perform to be worthwhile.

Now you know a bit about mortgages, the next two sections will explain how you can use a mortgage to create wealth using the concept of gearing.

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