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Mortgages and interest rates

This content applies to England & Wales

Information on the different types of mortgages and interest rates available.

What is a mortgage

The term 'mortgage' refers to the legal charge secured on the property in return for a loan. It is sometimes called a secured loan. 'Mortgage', however, is commonly used to describe the loan itself.

A mortgage loan is much cheaper than other types of loan since lenders charge a lower rate of interest than for unsecured loans. There are a number of different types of mortgage but they can usefully be divided into two main types: repayment and endowment.

Repayment mortgages

These can be divided into:

  • capital and interest – the monthly repayments are made up of interest on the loan and repayment of the loan itself. In the early years, most of the payments are made up of interest but as time passes the proportion of the payment made up of capital increases
  • interest-only – the capital (ie the amount borrowed) stays the same throughout the whole mortgage term. Only interest is paid in monthly installments. The borrower will need to arrange for another way to repay the capital on sale of the property or at the end of the mortgage term.

Buy-to-let mortgages are usually interest-only mortgages taken up by investors wanting to buy a residential property and let it out to tenants. The borrower must satisfy the lender's additional conditions and the interests paid is usually higher than normal residential repayment mortgages.

The terms of a repayment mortgage (ie costs, features, interest rates, loan's period and conditions) are set out in the mortgage contract. The contract is usually made up by different documents, typically by a specific mortgage offer supplemented by the lender's standard conditions of lending. In one case,[1] where its standard mortgage conditions allowed the lender to unilaterally increase the variable interest rate of a a 25-year buy-to-let tracker mortgage or to require full repayment of the loan on one month's notice, the courts held that the lender was not entitled to rely on such standard conditions because they were entirely inconsistent with the mortgage description as set out in the mortgage offer and, therefore, had not been incorporated into the contract agreed between the lender and the borrower.

Endowment mortgages

Endowment mortgages involve the borrower making two payments every month; one is a payment of interest to the building society and the other an endowment premium paid to an insurance company. The insurance company invests this premium and at the end of the term of the mortgage it provides a lump sum, which is used to pay off the loan. Since the premiums are invested and subject to changes in the market, there is a chance that the lump sum may be more or less than the amount of the original loan. If it is more, the borrower receives the difference tax-free but if it is less s/he will still owe the mortgage lender the outstanding balance. As a result, there is an element of risk involved with an endowment mortgage, the degree of which varies depending on the type of endowment mortgage chosen. Broadly, there are four main types:

  • Non-profit endowment mortgages
    These mortgages are guaranteed to repay the original loan but will not produce a surplus, however well the premiums are invested. They tend to be more expensive than repayment mortgages that do the same thing.
  • Full with profits
    These guarantee to pay the original loan and will produce an additional lump sum at the end. As a result, this is the most expensive type of policy.
  • Unit linked endowment mortgages
    Premiums are invested in shares and property and as a result can go up or down. If the investment goes well the original loan can be paid off earlier or sometimes premiums can be reduced. If it goes badly premiums may have to be increased.
  • Low-cost with profits endowment mortgages
    This is the most popular endowment mortgage. The premiums are lower because it only guarantees to pay a proportion of the original loan. If the company does well, there may be a surplus too. Some companies also offer low-start low-cost endowment mortgages. These have reduced payments in the early years and increased payments later.

Endowment mortgage shortfalls and mis-selling

One of the disadvantages of endowment mortgages is that the lump sum the borrower receives at the end of the term may not be enough to pay off the loan, leaving a shortfall. Borrowers should have received a re-projection letter from their lender, setting out whether the policy is on track to cover the full amount of the loan, and, if not, the amount of the shortfall.

Borrowers with a shortfall have a number of options, including:

  • changing the mortgage, for example, switching to a repayment mortgage or setting up a separate repayment mortgage to cover the shortfall
  • starting an additional savings plan to cover the shortfall, or
  • varying the endowment policy, for example, extending the term or increasing repayments.

Borrowers facing a shortfall should seek specialist financial advice, and should not cash in their endowment policy without getting advice.

Borrowers facing a shortfall may be able to argue that they have been mis-sold the policy if they can show that the company that sold them the policy did not give them full information about the mortgage at the time. This could include situations where the company selling the policy:

  • did not explain the risks involved
  • told the borrower that the policy was guaranteed to pay off the loan at the end of the term, or
  • did not explain other mortgage options.

Borrowers who can successfully show that they were mis-sold the policy can get compensation. There is usually a time limit to make a complaint. More information on mis-selling can be obtained from the Financial Ombudsman Service and Which? endowment information.

Other types of mortgage

There are a number of other types of mortgage available, including the following.

Individual Savings Account (ISA) mortgages

These work on the same principle as endowment mortgages, with the borrower paying interest to the mortgage lender and contributing to an ISA which invests the money in unit trusts that are exempt from capital gains tax. The advantage of an ISA mortgage is that it may perform very well and a large lump sum may be left once the mortgage is repaid. However, it is a high-risk option since investments can go up as well as down.

Pension-linked mortgages

These are similar to an endowment, but contributions are made to a pension plan. The contributions are eligible for tax relief. At the end of the mortgage term, the proceeds of the pension plan will repay the mortgage and provide a pension for retirement.

Islamic mortgages

Islamic law forbids the payment and receipt of interest. To avoid this, Islamic-compliant mortgages involve the transfer of property ownership from the seller to the lender, and subsequently from the lender to the buyer. The buyer pays instalments to the lender, but also pays rent rather than interest. Once the buyer has paid the final instalment, the property will be theirs.

The two main types of Islamic mortgages are ijara, a version of this type of mortgage called the diminishing musharaka, and the murabaha.

From 6 April 2007, those taking out Islamic mortgages have had protection from the Financial Services Authority (FSA). The mortgage conduct of business (MCOB) rules now applies to regulated mortgage contracts which will now include Home Purchase Plans (HPP - Islamic Mortgages). In essence these are a sale and lease arrangement.

At the risk of oversimplification, the process of buying the property under the most popular version of a HPP is roughly as follows: the buyer will choose a property, agree a price, undertake a survey, and then the bank or financial institution will enter into a contract to buy the property from the seller. The bank will grant a lease to the buyer and upon the expiry of the lease sell the property to the buyer at a previously agreed (higher) price, which will be paid by the buyer in equal instalments over a fixed term, irrespective of what happens to interest rates. The buyer does not own the property until the entire sum has been paid off, which is often 25 years.

The starting point in advising clients who are purchasing a property under a HHP would be to ask for a copy of or a specimen form of the HHP or 'Islamic mortgage' document. As the home purchase plan is essentially a sale and lease, the actual terms of the lease will be crucial in specifying the rights and obligations of both parties. The lease will also be subject to both common law and statutory protection and requirements. It seems that the Housing Act 1988 as amended by Housing Act 1996 could still apply where appropriate – for example, subject to high rent/low rent thresholds etc. Outside of this, then contractual requirements, common law rules and other statutes (such as the Landlord and Tenant Act 1954 or the Protection of Eviction Act 1977) will apply when appropriate.

Islamic mortgages are usually more expensive than standard mortgages. They are available from a limited number of lenders.

Interest rates

It is often very difficult for borrowers to compare the terms offered by different lenders since each one has a different way of calculating their interest rates. As a result, each lender must publicise its rate in the form of the 'annual percentage rate of the total charge for credit' (APR). This includes other costs such as valuation and legal fees and is the equivalent of the rate that would be payable if the interest was paid in one lump sum at yearly intervals at the anniversary of the loan.

Lenders frequently offer special rates of interest for particular purchasers or particular types of loan. The following are some examples:

  • variable rate – this is the usual rate lenders offer for mortgages and it can be varied at any time without notice.
  • discounted rate – lenders frequently offer some buyers a percentage point discount on their usual variable rate, eg to attract first time buyers. The discounted rate usually lasts for a set period, perhaps one to two years, before reverting to the variable rate.
  • fixed rate – the interest rate is fixed for a set period of time, usually for one to five years, before reverting to the variable rate. The advantage of a fixed rate mortgage is that borrowers know exactly how much their monthly repayments will be. If the variable interest rate is increased during this time, they will save money but if it is decreased, they may end up paying more.
  • deferred rate – these are designed to help those who have insufficient income to afford a mortgage at the usual interest rate in the early years of their mortgage but are confident that they will have a significant increase in income later on. The payments are reduced for up to five years during which time the difference between the payments made and what would have been the full payments if the market rate had been charged is added yearly to the outstanding balance and then accrues interest. After this period the mortgage payments will be increased to cover the outstanding amount over the remaining years of the term and at the usual market rate of interest. This method is more expensive than a similar mortgage that is not deferred, as interest will accrue on the unpaid interest in the first five years, and in many case there will be a steep rise in the payments after the initial period has ended.
  • capped rate – repayments will fluctuate, as with a variable rate mortgage, but the interest rate charged will not rise above a certain amount, or 'cap'. Capped rate mortgages are usually available for a set period of time, after which they will revert to a standard variable rate mortgage.
  • base rate tracker – these mortgages have interest set at a certain percentage (usually between 0.5 and 1 per cent) above the Bank of England's base rate. Base rate tracker mortgages are usually available for a set period of time, after which they will revert to a standard variable rate mortgage.

Lenders are more likely to charge an arrangement fee for fixed, discounted, capped, deferred rate, or base rate tracker mortgages. These mortgages may also be subject to the borrower taking out insurance through the lender.

Some mortgage lenders impose redemption penalties on borrowers who redeem the mortgage early or within a specific period of time, for example, within three years of taking the mortgage out. This is also more common with fixed, discounted, capped, deferred rate, or base rate tracker mortgages. Borrowers wishing to change mortgage should calculate the amount of money they would save in reduced interest rates and compare this against any redemption penalty and other charges such as arrangement fees.

[1] Alexander (representative of the 'Property 118 Action Group') v West Bromwich Mortgage Company Ltd [2016] EWCA Civ 496.

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