Interest rate type
Discount mortgages attract borrowers with their Ďbuy now, pay laterí appeal
Lenders offer an initial discount off their standard variable rate (SVR), which then reverts to the SVR once the set period of the discount is up. In a period of low interest rates, this can have the effect of making a large mortgage look affordable.
A 2% discount on a lenderís SVR of 6.75% means youíd pay interest at a rate of 4.75% for the period of the discount Ė but only as long as the SVR stayed at 6.75%. Your mortgage rate will stay 2% below the SVR but if interest rates rise and the lenderís rate follows, your payments will also increase. And your rate will revert to the now higher SVR once the discount period ends.
Equally, of course, if rates fall, your repayments will too. This is why discount mortgages can be a gamble and itís up to you to judge how comfortable you feel with a variable rate.
Discount mortgages vary in length from under a year to 10 years to the whole term.
Deciding how long a period to go for will depend on how confident you feel about interest rates but if youíre unsure donít go for more than two or three years.
One problem with discount mortgages is at some point the discount will end and your payments will increase to the standard rate. If you were enjoying a substantial discount this can mean a hefty rise in repayments. A stepped discount can help soften the blow by reducing the amount of the discount over a number of years.
For example, you might start with 2%, falling to 1% after one year and to 0.75% a year after that. This means you have to budget for more gradual increases to your mortgage payments.
If you have to budget, a discount mortgage probably isnít ideal for you. This is likely to include many first-time buyers but the initially low rate of a discount mortgage can provide much needed extra cash for other expenses incurred, particularly when buying for the first time, such as furniture and decorating. However, you do need to be ready to take on a certain amount of risk.
Discounted mortgages are most suitable for people who are looking for the cheapest initial payments at any given time but can afford any increased payments if interest rates rise. Likewise, if you believe that interest rates are likely to fall, or at least stay stable, a discounted mortgage makes continuing reductions to monthly repayments possible.
Fees and penalties
Discount mortgages frequently come with charges or tie-ins that prevent you from remortgaging or redeeming the loan for a set period of time. Theyíre not usually as severe as fees associated with fixed rates, however, because variable rates present less risk to lenders. If you need to move home or wish to increase payments during the discount period, however, this can prove expensive. Itís usually only worth paying the redemption penalty if you can make a saving elsewhere.
Also, some lenders will extend the tie-in period beyond the introductory deal with an overhang period. This is an early redemption charge (ERC) that lasts beyond the discount period. There are discounts without redemption charges, but inevitably they have less attractive rates. Itís a question of weighing up your needs to see which of the discount deals works best for you.
Need to know
- A discount from the lenderís standard variable rate (SVR) applies for an initial period
- The interest rate is variable and changes with the SVR
- Discounts can range from less than a year to 10 years or more
- With stepped discounts the rate is gradually increased until the end of the discount period, helping you to budget when the mortgage reverts to the SVR
- They are not ideally suited to people on a budget but are good for those wanting the cheapest initial payments
- Fees and charges are not as severe as for fixed rates
Information source: Mortgage Advisor & Home Buyer publication