What are the different types of mortgage?
Although the mortgage market is constantly changing, the most common types of mortgage are:
- Fixed rate mortgage - A type of mortgage where the interest rate remains constant (fixed) for a specified period, ensuring monthly repayments stay the same regardless of fluctuations in the Base Rate or market interest rates.
- Interest only mortgage - A mortgage where the borrower pays only the interest on the principal balance, with the principal amount remaining unchanged. At the end of the mortgage term, the principal amount of the mortgage must be repaid in full.
- Tracker mortgage - A type of variable-rate mortgage where the interest rate follows, or 'tracks', another specified interest rate, typically the Bank of England (BoE) base rate, with a set margin added on top. E.g. Base Rate + 1% or '1% over Base'.
- Standard variable rate (SVR) mortgage - A type of mortgage where the interest rate is set by the lender and can change at any time. Discount mortgages typically revert to the SVR after an initial fixed or discounted period has expired. The SVR is not fixed in relation to the Bank of England's base rate, but will typically be influenced by it.
- Offset mortgage - A type of mortgage that links your savings and, in some cases, your current account to your mortgage, allowing you to effectively reduce the amount of interest you pay on your mortgage by offsetting the balance against your savings.
- Capped rate mortgage - A type of mortgage where the interest rate can fluctuate, but won't exceed a pre-set limit or 'cap' during a specified period. If market interest rates fall below the capped rate, the interest rate on the mortgage can decrease.
- Flexible mortgage - A type of mortgage that lets borrowers overpay, underpay, or even take payment holidays, offering more flexibility in repayment terms compared to traditional mortgages.
What do all the different mortgage terms mean?
- Base rate - Often referred to as the 'Bank Rate', the Base Rate is the official interest rate set by the Bank of England (BoE), influencing lending rates offered by banks and financial institutions.
- Capital repayment - The portion of a monthly mortgage payment that goes directly towards reducing the principal balance of the loan, as opposed to paying off the interest.
- Decision in principle (DIP) - Also referred to as an 'Agreement in Principle (AIP)', this is a lender's provisional indication of how much they might lend you, based on an initial assessment of your financial circumstances, before a formal mortgage offer is made.
- Deposit - The amount of money you contribute towards your property purchase, typically expressed as a percentage of the property's total purchase price. E.g. A contribution of £100,000 towards a property with a purchase price of £400,000 is a 25% deposit (£100,000/£400,000 x 100).
- Early repayment charge - A fee charged by a lender if the borrower pays off a portion or the principal balance before a specified period has elapsed, typically applied to fixed-rate mortgages.
- Loan to value (LTV) - The ratio of the mortgage amount to the value or purchase price of the property, expressed as a percentage. E.g. A mortgage of £300,000 taken out on a property valued at £400,000 has a loan to value of 75% (£300,000/£400,000 x 100).
- Mortgage term - The length of time over which a borrower agrees to repay the loan in full, typically spanning between 15 to 30 years.
- Outstanding balance - The remaining amount of a loan or debt that has yet to be repaid, not including upcoming interest or fees.
- Principal balance - The initial amount of a loan or mortgage, excluding any interest or additional fees.
- Remortgage - When a borrower replaces an existing mortgage with a new one, either with the same or a different lender, typically to secure a better interest rate or to release equity from a property.
- Standard variable rate (SVR) - The default interest rate set by a lender that a mortgage reverts to once any initial deal or fixed rate period ends.
How much can I borrow?
Mortgage lenders determine how much you can borrow based on a combination of factors, your income (or aggregate income if there is more than one buyer), credit history, existing debts, outgoings, the loan to value (LTV), the desired term of the mortgage.
When you apply for a mortgage, the lender will carry out an affordability assessment to ensure you can manage the monthly repayments now and in the future, especially if interest rates rise.
As a rule of thumb, most lenders will lend 4 to 4.5 x your salary - some may go to 5 x.
How are my monthly repayments calculated?
Mortgage monthly payments are calculated based on several factors, but primarily the principal amount borrowed, the interest rate, and the term of the loan.
Fixed rate mortgages
With a fixed rate mortgage you will make the same monthly repayment every month. With each payment, a greater percentage will go toward the principal balance, and a lower percentage will go toward paying the interest. This is called 'amortisation'.
Calculating a monthly repayment is more complicated than it may seem at first, as they are calculated on compound interest.
- You borrow £300,000 on a 25-year repayment mortgage term with an initial fixed 5 year interest rate of 6%,
- At the start of year 1 you owe the bank £300,000.
- Your annual payments are £23,196 (£1,933 x 12) for the initial 5-year period.
- £18,000 of this 1st year payments covers the 6% interest (i.e. 6% of £300,000 = £18,000).
- The remaining £5,196 (£23,196 - £18,000) is deducted from your principal balance, leaving an outstanding balance of £295,804.
- You start year 2 owing the bank a lesser amount of £295,804.
- Your annual payment in year 2 is still £23,196 (£1,933 x 12) and the interest rate is still 6%.
- This means you will pay less in interest: 6% of £295,804 being £17,688.
- So in year 2 you will have made a greater contribution of £5,508 (£23,196 - £17,688) towards paying off the principal balance than you did in year 1.
- This continues year-on-year until the end of the mortgage term.
Our mortgage calculator shows you the amount you pay in interest and repayments each year and the point at which a greater percentage of your monthly payment goes towards the principal balance.
Variable rate mortgages
With variable-rate mortgages, the monthly payment can change when the interest rate changes. If the interest rate increases, you'll pay more each month, and if it drops, you'll pay less.
The initial calculation of a monthly payment for a variable-rate mortgage is the same as for a fixed-rate mortgage. However, if the rate changes, the monthly payment will need to be recalculated based on the new rate.
We can use the following formula:
(M) Monthly payment
(P) Principal Amount = £300,000
(r) Interest Rate = 6% per annum (0.06)
(n)Term of the Loan = 25 years (300 months)
To find the monthly interest rate, divide the annual rate by 12:
r monthly = 0.06 / 12 = 0.005
Using the formula, the initial monthly payment is calculated to be approximately £1,932.90.
However, with a variable-rate mortgage, if the interest rate changes after a certain period, you would use the same formula but with the new interest rate to determine the new monthly payment. Over the 25-year term, you may need to recalculate the payment multiple times, depending on how often the rate changes.
The figures generated by this mortgage calculator are for illustrative purposes only and should not be considered as formal financial advice. The results are based on the information you provide and various other estimations, and they are not a guarantee or quotation from any mortgage lender. Always consult with a qualified mortgage advisor or financial professional before making any decisions based on the calculator's results.
Chris Salmon, Director
About the author
Chris Salmon is a co-founder and Director of Quittance Legal Services. Chris has played key roles in the shaping and scaling of a number of legal services brands and is a regular commentator in the legal press.