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Choosing a mortgage in the UK is not easy, particularly when remortgaging as there are so many different mortgage products available in the market and knowing what is best can be tricky. We previously looked at the preparation steps you should do ahead of remortgaging, in this remortgage guide, we look at the important factors that will help you keep your costs down when choosing a suitable mortgage. The three factors listed below can help you a great deal in minimizing the overall cost of your mortgage.
If you are looking for a new mortgage, you will come across many deals where lenders are offering attractive interest rates for the first few years of the mortgage. This period is also known as the incentive rate period, and it can be between 2 and 10 years. If chosen carefully, such incentivized rates can prove to be very beneficial to borrowers. However, many people don't spend enough time and attention on choosing the right incentive period. We present a few tips on how to make the most out of the incentive rate period in a mortgage deal.
As an existing homeowner you will already know that in a fixed rate mortgage the monthly repayments are fixed for a certain period. You will find many deals in the market, named as 2-year fixed or 5-year fixed mortgages. As a general rule, if you go with a fixed interest rate for a longer period, you will have to pay more. So, a 5-year fixed mortgage will charge a higher interest rate than a 2-year fixed mortgage.
If you are going for a fixed-rate mortgage, you should know how long you need the certainty of fixed monthly repayments. By choosing the correct incentive period, you can get substantial savings.
You should not choose a mortgage simply by the name of the deal. For instance, you may think a 2-year deal will charge the initial or incentive interest rate for 2 years. But that may not be the case because typically such deals will have an end date. The incentive period may vary depending on the time it takes for completing the mortgage deal.
Example 1: Let's look at a historic mortgage deal from the Yorkshire Building Society, named Yorkshire BS Flexi 2 Year 1.69% Fixed. You would think the mortgage rate in this deal was fixed for 2 years. However, if you look carefully, the mortgage contract and deal is valid up to 31 Jan, 2017. So if you had taken this mortgage product in March 2015, you would not get a fixed rate for full 2 years but 22 months. 2 Months may seem quite small but it can make a big difference, particularly if you are doing your sums correctly..
If you switch deals too often, you may have to pay more. Among all the incentive rate periods, the most popular are 2-year deals because typically they offer the lowest interest rates. However, the arrangement fees on these deals are usually the same as longer deals. So if you have four separate deals, each of 2 years, over a period of 8 years, you will have to pay an arrangement fee every time you switch a deal. Assuming an average arrangement fee of £1,500, you will end up paying £6,000 over 8 years. Instead, if you take two deals -- one deal of five years and one of three years, you will pay only £3,000 in arrangement fees.
There are also other mortgage fees and costs related with remortgaging, use our Remortgage Fees Calculator to understand how those costs could add up for you.
The choice of the incentive period will also depend on how many years you plan to stay in a property. If you plan to move to another property within 3 years, you should avoid taking a 5-year incentive period because there is an extra charge for repaying before the incentive period. This extra charge is applicable either if you sell the property before the term or if you replace the mortgage with another one from a new lender.
Apart from choosing the term of the incentive period, the term of the mortgage also plays an important role in the overall cost of the mortgage. Traditionally, people in the UK have opted for 25-year loan terms. However, recent trends have indicated that many first-time buyers are opting for longer loan terms, sometimes as high as 40 years.
The Council of Mortgage Lenders identified that, in the three months before September 2014, more than 27% of first-time borrowers opted for longer terms. The trend towards long term mortgages has increased consistently through to 2020. One of the key reasons behind people choosing longer loan terms is low monthly repayments as this allows households spare cash for other expenses.
Another advantage of a longer loan term is that it increases the chances of a borrower securing a mortgage. That's because longer loan terms allow borrowers to pass the affordability tests laid out by the new mortgage lending rules. As per the affordability tests, borrowers are evaluated based on their monthly expenditures and whether they can afford the monthly repayments after deducting their expenditures. If the affordability tests show that a lender is not eligible for a 25-year mortgage, borrowers can increase the loan term to 35 or 40 years and secure the mortgage.
Example 2: Let's say you want to go for a mortgage of £250,000 at an interest rate of 5%. If you opt for a 25-year mortgage, your monthly repayments will be £1,461 per month. However, if you go for a 40-year mortgage, your monthly repayments will be £1,205. For most families, savings of around £256 per month can make a big difference to the monthly finances. Also, for the lender, a monthly payment of £1,205 may seem more affordable for your income as opposed to a payment of £1,461.
However, a longer mortgage term increases the overall cost of the mortgage, as compared to a shorter mortgage term.
Example 3: Continuing with the example given above, if you go for a 25-year mortgage, you will be repaying a total amount of £438,443 over the term of the loan, including interest. However, if you go for a 40-year mortgage, the overall cost of your mortgage will be £578,636. So you will end up paying £140,193 more with a longer loan term.
In any case, a shorter-term mortgage is a better option, because it reduces the overall cost of a mortgage, and it also allows borrowers to be debt-free sooner when compared to a longer term. Therefore, a mortgage of 35 or 40 years should be a last resort.
Mortgage lenders provide an incentive rate period is they want to attract borrowers to a certain product. The lender hopes the borrower will stay with the same mortgage even after the incentive period ends and subsequently pay higher interest rates. As we discussed above, the longer you stay in a mortgage, the more profitable it is for the mortgage lender.
Because of this, lenders impose an early repayment charge to make sure that borrowers don't change lenders too frequently if they get cheaper deals elsewhere.
You need to pay early repayment charges in different scenarios as listed below.
Typically, most mortgages will allow a repayment of a certain percentage, say 10%, of the original debt every year without any early repayment charges.
Charges for early repayments vary by different mortgage products and lenders. The repayment charges can be between 1% and 5% of the repayment amount. So if you are repaying £200,000 and your lender is charging you 1% for repayment, you will have to pay £2,000. Others may calculate repayment charge as a percentage of the outstanding mortgage amount.
Also, the repayment charges vary depending on when you are repaying. For example, you will have to pay a higher charge for any repayments made in the first year, and the charge will be lower if you repay in the second year. Sometimes you can also find deals with no early repayment charges. You should check your mortgage offer in detail for any early repayment charges.
Example 4: HSBC levies an early repayment charge on its fixed rate mortgages in the following conditions.
You can also save on early repayment charges if your mortgage lender charges interest on a monthly, quarterly, or yearly basis. Different mortgage lenders calculate interest at different times. A majority of lenders calculate interest on a daily basis. However, some may calculate it less frequently.
It is important to know how interest is calculated on your mortgage, because if it is calculated every month, every quarter or every year, you can benefit by timing your early repayments. And if the lender calculates interest on a daily basis, the timing of overpayment doesn't matter.
Example 5: Let's say you have a mortgage of £250,000, and your lender calculates interest once in a year on 31st December. Suppose in 2014, you want to make an early repayment of £25,000. If you make this payment before 31st December 2014, you can save on the interest on this amount from next year. However, if you repay the same amount in January 2015, you will have to continue paying interest on this amount for the whole of 2015 because the lender is calculating interest on an annual basis.
It is important to choose an appropriate incentive rate period and an overall loan term. Similarly, you should be aware of early repayment charges. If you study these three factors carefully, you can minimize the overall cost of your mortgage.
Use our remortgage calculator to calculate how the overall cost of your mortgage varies with different interest rates and different loan terms.