With so much talk about rate cuts on the horizon, discount mortgages look tempting. These variable-rate mortgages where the interest rate goes up and down during the term of the loan could offer enticing savings for borrowers who dont want to lock themselves into a fixed deal in case rates drop further.
The market is awash with bargains, but not every discount equates to good long-term value, and buyers need to be wary of the risks of playing the discount game.
What are discount mortgages?
A discount mortgage offers a reduced rate on the lenders standard variable rate, or SVR, for a limited period. After the initial period the interest rate reverts to the lenders full SVR for the rest of the term. So, a lender with an SVR of 6.6 per cent offering a 2.0 per cent discount for two years means you would pay 4.6 per cent for the first two years, and 6.6 per cent thereafter (assuming the SVR stays constant).
The discount period can last anywhere from six months to ten years, although the shortest deals generally offer the deepest discount rates. Some lenders offer stepped discount loans, where the discount reduces each year over a set period.
Unlike fixed-rate loans, where your payments will not change for the length of the initial period, discounts are variable and will change along with the lenders SVR if the Bank of England decides to move base rates up or down and the lender changes its rates to reflect this.
When rates go down, borrowers will reap the benefits of lower payments, but they also take the risk that rates could rise and their payments will increase.
Why should I choose a discount mortgage?
As their rates can move up or down, discount loans are not for everyone. Discount mortgages are only good for buyers who can afford to be a bit wrong on interest rates and can take the risk that their repayment rates could rise, advises Melanie Bien of Savills Private Finance, an independent broker. First-time buyers and other cash-strapped borrowers are often better off with a fixed-rate deal because they know their monthly payments from the start and will not be caught out by any rate hikes, says Bien.
That said, discount mortgages are appealingly cheap at the outset, and can be very useful for buyers who need a lower rate at the beginning of their mortgage when cash is often tight. And unlike fixed-rate loans, borrowers benefit even further if interest rates are cut.
Discount mortgages are universally appealing to all types of buyers and remain one of the most popular products in the market, especially in todays low-rate environment, explains Rob Clifford of Mortgage Force, an independent broker. Many lenders will even cut the arrangement and other upfront fees that come standard on fixed-rate products, he says.
Watch out!
But in the hunt for low rates, borrowers need to avoid a variety of pitfalls. Many of the best-looking discount deals youll see on newspapers personal finance pages come laden with penalties and other conditions that may come back to haunt you.
It is important to note the difference between discount deals, which track the lenders SVR, and tracker mortgages, which follow the Bank of Englands base rate. Where a tracker mortgage automatically passes on any base rate changes, discount loans only change according to the lenders SVR. Lenders set their SVRs independently and there is no guarantee your lender will pass along all the savings when rates are cut.
Cheap rate or long-term value?
Beware the cheapest deals on the market which can charge high upfront fees that all but wipe out the savings. At 3.99 per cent, Birmingham Midshire Building Societys two-year discount tracker looks brilliant, but the £1,499 arrangement fee is more than triple what most lenders charge and raises the true costs considerably.
Rarely will the loans with the deepest discounts come out on top in terms of long-term value, explains Louise Cuming of Money-supermarket.com, a mortgage search engine.
Also, watch out for discounts that tie you in beyond the initial period after the loan reverts to the lenders SVR. While these loans often top the best-rate tables and offer impressive initial savings, they are often poor value, and borrowers can find better deals with more flexibility elsewhere.
Independent mortgage comparison websites like Moneysupermarket, Money Extra and Moneyfacts can help you dig deeper by comparing the total costs of a mortgage over a set number of years, including upfront fees, rate increases, tie-ins and any redemption penalties that may be charged.
With an initial rate of 3.99 per cent, Skipton Building Societys three-year Discount Plus mortgage might look a better deal than Cheshire Building Societys three-year discount product, which has a rate of 4.45 per cent. But after the first year, the Skipton loan jumps to 5.49 per cent, and winds up costing nearly £1,900 more than the Cheshire loan over three years. The total, or true, three-year cost with the Skipton loan would be £36,360, compared to £34,464 with the Cheshire product, according to Moneysupermarket.com.
The Cheshire deal also comes with handy flexible repayment features like payment holidays and free overpayments, which you can redraw if you end up needing the money later on.
While deals like Cheshires are not as cheap at the outset, they offer real value for buyers who dont need a super-low rate early on. Flexible repayment features are also valuable perks for those whose incomes might fluctuate throughout the year or for borrowers who simply want to pay off their mortgages early.
How to choose?
While all discount loans try to offer short-term savings, choosing the right one will depend on your lifestyle, explains Charcol spokesman Ray Boulger. Theres no point paying a higher initial rate for flexible repayment features if you are not likely to overpay on your mortgage. New parents, for example, who are struggling with huge baby bills might be best off with a really cheap rate initially, even though they know their payments will ramp up down the road.
Boulger sums it all up: As a rule of thumb theres no such thing as a free lunch. But some lunches are better than others.
