Fixed-Rate Mortgage: What is it and How it Works
A fixed-rate mortgage ensures your interest rate won’t change for the first two to 10 years of repayment. When the fixed period ends, you can pay the standard variable rate or remortgage.
With a fixed-rate mortgage, the interest rate charged on your home loan is set in stone for a specific period. For example, with a two-year fixed rate, you know that your interest rate ‒ and therefore your monthly repayments ‒ won’t change during that time.
You can opt for different lengths of your fixed rate, ranging from two years up to 10.
The big selling point is the certainty that this provides. It’s much easier to budget if you know precisely what your mortgage bill will be each month.
The downside is that if interest rates fall you won’t get the benefit of a reduction to your mortgage repayments.
The lowest fixed-rate mortgages
A number of different factors determine the interest rates charged on fixed-rate mortgages.
The first is the length of the fixed rate. Borrowers pay a premium for the certainty offered by fixed-rate deals, and that premium increases as the length of the fixed rate does. So a two-year fixed-rate mortgage is likely to come with a lower interest rate than a five-year fixed mortgage, for example.
Another important consideration is the loan-to-value ‒ how the size of the loan compares to the overall value of the property. The lowest rates are reserved for those borrowers who are taking out a mortgage at 60% LTV or less, which means they will put down a deposit of 40% or more.
Then there is the arrangement fee. This is a fee charged by lenders on many mortgages, which borrowers pay in order to reserve the product they have chosen. It is often around £1,000. Mortgage products with the lowest interest rates tend to come with significant arrangement fees, with fee-free deals generally carrying a higher interest rate. Nonetheless they can work out cheaper overall, so it’s important to compare the total cost of mortgages including fees, rather than just focusing on the interest rate.
Finally, there is your own credit worthiness. Lenders will only offer their best deals to borrowers who they believe will repay the deal on time ‒ if you have black marks in your credit history, for example as a result of late repayments on a credit card or phone bill, then you may not be accepted, or you might be offered a deal with a higher interest rate.
A mortgage adviser may be able to steer you toward lenders who are most likely to accept your application, in addition to helping you work out what sort of mortgage best suits your needs. They will also have access to lenders and products that you cannot get directly.
» MORE: Compare fixed-rate mortgages
What happens when my fixed rate ends?
When you come to the end of your fixed-rate period, the interest rate charged on your home loan changes. You will now be charged your lender’s standard variable rate (SVR), a rate which the lender sets and can increase or decrease at any time, no matter what is going on with the base rate, set by the Bank of England.
Not only does the SVR mean uncertainty over the monthly mortgage payments, they are also substantially higher than the best rates on the market.
For example, if a fixed rate were 2% for two years and the standard variable rate is 5% at the start of year three, then the rate would adjust upward increasing the monthly payment.
As a result, it’s common for borrowers to remortgage to a new home loan when they come to the end of their fixed rate, in order to avoid the payment shock of transferring onto the SVR.
Can I leave my fixed-rate mortgage early?
You will be able to remortgage to another deal during the fixed term of your mortgage, though there will be a financial penalty for doing so. It’s called an early repayment charge (ERC) or redemption penalty and is calculated as a percentage of the sum being repaid.
So let’s say you are remortgaging your £200,000 mortgage to a new lender, but there is a 3% ERC in place. You will therefore have to pay a fee of £6,000 in order to remortgage.
ERCs are an important consideration when it comes to selecting the right fixed-rate mortgage. You don’t want to tie yourself into a lengthy fixed rate, with significant ERCs, if you are likely to need to move to a new deal ‒ or move house ‒ during the term of that fixed period.
Is a fixed-rate mortgage better than a variable rate mortgage?
Ultimately this will come down to your own circumstances and attitude to risk.
A variable rate mortgage may have a lower interest rate at the outset and if interest rates fall then your repayments will, too. However if interest rates rise your repayments will go up, meaning it may end up costing you more.
If you are happy to accept this risk then a variable mortgage may suit you. However, if you prefer the certainty of knowing exactly what your repayments will be for the next couple of years then a fixed-rate mortgage is likely to be more appropriate.
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John Fitzsimons has been writing about finance since 2007. He is the former editor of Mortgage Solutions and loveMONEY and his work has appeared in The Sunday Times, The Mirror, The Sun and Forbes. Read more