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Mortgage Types. Understanding Mortgages: Types of Mortgage

Understanding Mortgages: Types of Mortgage

For most people, getting a mortgage is one of the most important financial decisions in their lives. If you go out to seek a mortgage, you will see hundreds of mortgage products. As a borrower, it is important that you understand the different types of mortgages so you can choose the one that is best suited for you. In this article, we look at the different type of mortgages available in the market.

Type of mortgages based on interest rate

  • Fixed rate mortgages
  • Variable rate mortgages

Fixed rate mortgages:

The interest rate on fixed-rate mortgages remains fixed over a short period of say 2 years or 5 years. Typically, you will see the term of mortgage in the product's name.

Example 1: Some examples of fixed rate mortgages are Chelsea Building Society 2-Year 1.38% Fixed mortgage. As you can see from the name, this mortgage charges a fixed interest rate of 1.38% for a period of 2 years. Other examples of fixed rate mortgages are Yorkshire BS Flexi 2 Year 1.39% fixed, Post Office 2 Year 1.43% Fixed and HSBC 2 Year 1.49% Fixed Special.

At the end of the term, the mortgage moves to a higher variable rate. For instance, after two years the interest rate on the deal from Chelsea Building Society is 5.45% for the rest of the term.

Advantage of fixed rate mortgages:

  • Monthly payments remain the same over the entire loan term, which helps in better planning of budgets. For example, for a 2-year 1.38% fixed rate mortgage, the monthly payment will be fixed at £10,568.16 every month for 2 years giving you some certainty for planning your budget.

Disadvantages of fixed rate mortgages:

  • Typically, interest rates on fixed rate mortgages are higher as compared to variable rate mortgages.
  • If there is a fall in interest rates, there is no benefit for you.
  • If you want to make an early repayment, you will have to pay an extra charge, which could be 1% or 2% of the total loan amount.

Variable rate mortgages:

The interest rate on variable mortgages changes over the term of the loan, based on factors such as interest rates set by the Bank of England. With variable rate mortgages, you need to be prepared for higher monthly repayments if there's an increase in interest rates.

There are different types of variable rate mortgages:

  • Standard Variable Rate (SVR)
  • Discount mortgages
  • Tracker mortgages

Standard Variable Rate (SVR):

SVR is the normal interest rate charged by mortgage lenders. SVR lasts for the entire term of the mortgage or until you take another mortgage. Usually, SVR changes in line with movements in the base rates set by Bank of England. SVRs are not commonly available in the market nowadays.

Discount mortgages:

In this type of mortgages, lenders offer a discount on the SVR for a certain period, for say two to three years. However, as a borrower you should not go simply on the discount, but also look at the SVRs charged by different lenders. One bank may provide a discount of 2% on an SVR of 5%, and another bank may offer a discount of 1.25% on an SVR of 4%. After discount, you will pay an interest of 4% to the first bank, and 3.5% to the second bank. So even though the first bank is providing a higher discount, you will get a better deal with the second bank.

Advantages of discount mortgages:

  • You will be paying a lower rate of interest for an initial period, resulting in lower monthly repayments.
  • If there is a reduction in the SVR by the lender, it will be beneficial for you.

Example 2: Furness Building Society is offering a discount rate mortgage of 1.50% - SVR minus 4.04% for 2 years. So, for the first 2 years, there's a 4.04% discount on the actual SVR of 5.54%, resulting in an interest rate of 1.50% for the first two years. After two years, you will have to pay an SVR of 5.54% on the loan for the remaining term. There's an early repayment charge of 3% for the first 2 years (or the discount period).

Tracker mortgages:

The interest rate on tracker mortgages is directly correlated to another interest rate, let's say, the base rate set by the Bank of England, plus some extra percentage. If there's a 1% increase in the base rate, your interest rate will go up by 1%. Typically, trackers are available for a short period of two to five years. However, some tracker offers may be available for the entire term of the mortgage.

Example 3: Nationwide is offering a tracker rate mortgage of 1.44% - Bank Base Rate plus 0.94% for 2 years. This means during the first two years, the interest rate is related to the base rate of Bank of England, which is 0.5% as of December 2014, plus 0.94%. This works out to a rate of 1.44%. If the Bank of England base rate goes up by say 0.5%, the rate of this mortgage will also go up by 0.5%.

Advantages of tracker mortgages:

  • You can be assured that your interest rate will increase only if there's a change in the external financial environment, and not whenever the lender wants to increase the rates.

Disadvantages of tracker mortgages:

  • There is uncertainty about how much you are going to repay in the future. If there's a substantial jump in the base rates, you will end up paying much higher.

Offset mortgages:

In this type of mortgages, your savings and current accounts are linked to your mortgage account. As a result, you pay interest only on the difference between the two accounts. Note the amount of monthly repayments will be the same as other mortgages, but if your savings are high, the difference will be considered as overpayment. This can help in clearing your mortgage earlier than the original term.

Example 4: Let's say you take a mortgage of £250,000 and have £100,000 in your savings account. So, you will be paying interest only on £150,000 (£250,000 - £100,000). Examples of some offset mortgage products are Chelsea Building Society Flexi 2 Year 1.58% Fixed Offset or First Direct 2 Year BBR+1.09% Offset Limited Edition.

Type of mortgages based on repayment structure:

Whether you opt for a fixed rate or a variable rate mortgage, all mortgages will require you to make monthly repayments. Based on their repayment structure, mortgages can be of two types:

  • Repayment mortgages
  • Interest-only mortgages

Repayment mortgages:

In repayment type mortgages, your monthly repayments include both principal repayment and interest. Repayment calculations are done in such a way that by the end of the term (say 25 years) you would have paid the principal in full along with the interest due for the period.

During the early years of the mortgage, a large part of the monthly repayments goes towards interest and a smaller part towards the principal. And as the debt goes on decreasing over the years, the interest component in the monthly repayments starts reducing, and the principal component starts increasing.

Example 1: Let's say you take a mortgage of £250,000 at an APR of 4.9% for 25 years. Assuming a constant interest rate, your monthly repayment will be £1,447 each month. For the first 10 years, you will be making total payments of £173,640 (£1,447 x 12 x 10). Out of this amount, the principal component will be only £65,815. However, on a similar payment of £173,640 for the next 10 years, your principal component will be £107,324. That's because for the next 10 years you are paying interest on a lesser amount as you have already repaid some amount from the original loan.

Some borrowers are worried about the fact that the interest component is higher during the initial period of the mortgage. They want to know if they go for a remortgage, say after 10 years, whether their monthly repayments structure will again tilt towards interest. There's no reason to worry because if your debt is the same, your monthly repayment structure will not change because of a remortgage.

Interest-only mortgage:

In an interest-only mortgage, your monthly repayments will comprise only of interest. The monthly repayments are typically lower in an interest-only mortgage as compared to a repayment mortgage.

Example 2: Let's say you take an interest-only mortgage of £250,000 for 25 years at an annual APR of 4.9%. Your monthly repayment will be £1,021, which is lower than the monthly repayment of a repayment type mortgage for a similar loan amount. At the end of 25 years, you would have paid a total of £306,250. However, because it is an interest-only mortgage, your entire repayment comprised of interest, and you will still owe the original £250,000 to the lender.

As per new mortgage lending rules announced in April 2014, lenders are allowed to provide interest-only mortgages only to borrowers with a solid repayment plan. If you need an interest-only mortgage, you will need a savings plan for repaying the original loan amount.

Between the two methods, repayment is a better option. One, it is difficult to get an interest-only mortgage. Even if you get one, an interest-only mortgage is not recommended. Ideally, it is good to have a debt repayment plan for both types of mortgages. But with a repayment type mortgage, even if you don't have a repayment plan and you simply make your monthly repayments regularly, you can be debt-free at the end of the term. Also, your interest liability starts reducing as the debt is reduced every year.


Depending on your preferences, you have many mortgage options. Use our mortgage calculator to calculate the monthly repayments and total repayment for mortgages at different interest rates and different loan terms.