Fixed rate vs tracker and variable SVR mortgages,,,

Deciding on whether to take out a fixed rate or tracker loan can be tricky.

And, with Bank of England base rates at rock-bottom, borrowers will need to carefully consider their options before locking into a decision - although tracker mortgages may seem like a good option right now, a sudden, steep, rise in rates could see your interest payments shoot up without warning.

How do mortgages work?

Decision making: should you go for a tracker or fixed rate mortgage?

The most popular, and generally best value-for-money, deals offered by lenders are those that include an initial special rate - either fixed or variable - for a set period, typically between two and five years.

After this initial deal period has ended,  borrowers will then pay back their mortgage at the lender's standard variable rate, which was once around 2 per cent above the bank rate.

However, the banking crisis and subsequent slashing of the base rate down to 0.5 per cent changed things. Now SVRs range from 2 per cent above the base rate to above 5 per cent or 6 per cent.

Good value mortgages will allow borrowers to leave at a minimal cost once the initial deal period has ended. They can then attempt to secure another good value deal. However, many are currently temporarily better off staying on a standard variable rate, if their lender has cut this substantially.

Inertia tends to keep many people with their existing lender, but shrewd borrowers can shop around and take advantage of the system. For example, while the SVR is low now, it will rise in future when the base rate does and securing a good value fixed rate may be a better choice than staying put.

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Standard variable rates

Borrowers who fail to regularly monitor the value of their mortgage deal tend to end up on standard variable rates. The repayments on these tend to be uncompetitive when compared to special offers on the market.

The rate moves broadly in line with the Bank of England's base rate, although the lender is not obliged to pass on the changes.

Tracker mortgages

These deals work in a similar way to variable rate mortgages. The difference is that the mortgage tracks the Bank of England base rate rather than the lender's SVR.

The advantage is that you are guaranteed to benefit from the full effect of any rate cut - lenders frequently shortchange borrowers by reducing their SVR, say, 0.2 per cent when the central bank has cut by 0.25 per cent. Of course, you are also guaranteed to feel the pain of rate rises.

Some borrowers on tracker mortgages saw interest payments slashed to nothing, thanks to the base rate falling to 0.5 per cent in March 2009. This was because previously lenders had offered trackers at below bank rate, with some at bank rate minus 0.5 per cent or more. This meant that as interest rates fell, their rate dwindled away to zero.

Tracker rates were raised to substantially above the bank rate, as interest rates fell this low, and the best deals on the market are typically 2 per cent or more above it. This may sound like a good rate, the base rate will inevitably rise in the future - and so will your rate.

Anyone considering a tracker should try and secure one with either no early redemption charge, making it free to leave for another deal, or with a cap on how high rates can go.

While your tracker mortgage rate is low, you can take the opportunity to overpay on your mortgage, shortening the total length of time it takes you to pay off your mortgage, and cutting the amount of interest you pay.

Fixed-rate mortgages

If you have stretched yourself in trying to buy a property or if you are someone who likes the security of knowing your repayments won't change, then a fixed-rated deal is probably for you.

But you do have to pay for this additional security - rates on fixed rate deals are higher than for variable special offers and many lenders have high fees for their best deals.

Two-year fixed rates are the most popular with British homeowners, but increasing numbers of borrowers are turning to longer term fixed rates of five or ten years. These longer measures give more security and cut down remortgaging costs, but you will have to pay a hefty penalty to leave.

If you choose to do this, make sure that your loan is portable and so can be carried with you if you decide to move house, but remember any extra borrowing will generally have to be with the same lender.

Discounted mortgages

These deals are linked to a lender's SVR but tend to track it at a discount or margin above it. But they leave you exposed to the danger of rising interest rates, as their rate will rise when the bank rate does. The pay-off is that rates tend to be more attractive than fixed-rate deals. With SVRs falling to low levels as the base rate was slashed, discounted deals have become scarce.

However, because your discount rate tracks your lender’s SVR – and you have no control over what that SVR is – a discount mortgage does not offer much rate stability.

Borrowers with large discounts below their lenders’ SVR may be in a particularly vulnerable position when their discount mortgage deals come to an end. This is because they could face large and sudden rate hikes when they’re transferred onto their lenders’ SVRs.

So, if you’re on a tight budget and need your repayments to stay the same from month to month, it makes more sense to choose a fixed rate mortgage.

Fixed vs tracker

 

Your primary consideration should be about what repayments you can afford if rates rise. But if you do want to take a gamble with a tracker, you should first compare rates and then calculate the repayments based on the projections you make.

For more information read and bookmark This is Money's mortgage expert Simon Lambert's What's next for mortgage rates and should you fix?

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The pitfalls

Lenders offer special offers on the hope that after they end, you will forget to move your mortgage and pay the punishing rates on their SVRs.

Also, some deals lock you in, charging a fee if you want to move the deal within a certain time-frame. For example, a two-year fixed rate deal might have a 'collar' that stops you switching deals for a further three years.

To avoid these, ask only for deals with no extended redemption penalties. If you intend to leave a mortgage during a deal period, it is likely that you will incur early repayment charges, so make sure you know how much these will be as bills can be very large and mean moving loans is not economically sensible.

A further consideration is that frequently switching deals will cost you money. Each time you will face an administration charge of anything from £100 to £500, and a valuation fee of £150 to £200. Your existing lender may also apply an exit fee, which is separate from the redemption charge.

Make sure you factor these costs into the equation when deciding whether to remortgage.

This is Money has partnered with mortgage broker London and Country. Compare best-buy mortgage rates and get fee-free advice here