This Is Called An Interest Rate' Collar'

Category: Finance, Mortgages.

As well as choosing between the basic types of mortgage, there is a wealth of interest rate options too: �Variable rate The'standard' option in the UK. Interestingly, this is not the norm in some other countries, where the uncertainty of variable rates is considered too risky. �Base rate tracker A variable rate that moves up and down in line with changes in some reference interest rate, such as the Bank of England base rate. �Fixed rate You lock into a set interest rate for a fixed period of time, which could be just a year or two or as long as ten years.

The interest you pay rises and falls with interest rates generally in the economy, making it hard to know from one year to another what your payments will be. At the end of the term, you usually revert to the normal variable rate. The penalty period sometimes extends beyond the fixed- rate term: for example, you might fix the rate for three years but face early redemption penalties for five years in all. Usually an arrangement fee has to be paid when you take out this type of mortgage, and there will be hefty penalties if you want to pay off the mortgage: for example, to switch to a cheaper lender. This means that you are not only locked into the fixed rate but also into whatever variable rate that lender subsequently charges. In response to consumer and regulatory pressure, many providers now offer fixed- rate mortgages where there is no' penalty overhang' - in other words, penalties for paying off the mortgage are not charged once the fixed- rate period ends.

However, this practice is widely considered to be unfair. In general, you should not accept a fixed- rate loan with a penalty overhang. If you are right, you will be quids in. Choosing a fixed rate can be a speculative move- you choose a fixed rate if you expect interest rates generally to rise. If you are wrong and variable rates fall, you will have lost the gamble and be stuck with the higher fixed rate. This is useful if money is tight at present but you expect the situation to improve, for example as you work your way up the promotions ladder at work.

But fixed rates also have the advantage that you know what your payments will be, which helps you to plan your budgeting. �Discounted rates Some mortgages, particularly those aimed at first- time buyers, have a lower rate of interest in the early years. But make sure that what is on offer is a genuine discount. As with fixed- rate deals, there are early redemption penalties if you pay off a discounted- rate mortgage in the early years, and usually the penalty period extends beyond the discount period. Beware of deals where the interest saved in the early years is simply deferred and added to the outstanding loan- this is an expensive way to cut costs in the early years and can cause problems when you come to move house if the outstanding loan has become larger than the value of your home. For example, even a discount for just one year may go hand in hand with redemption penalties in the first five years. There might also be a floor below which the interest rate will not fall, even if general rates go lower. This means that you may be locked into the lender's standard variable rate for some time. �Capped rates A capped rate varies in line with general interest rates but is subject to a limit: the rate is guaranteed not to rise above the interest rate cap.

This is called an interest rate' collar' . Capped rates give you some of the certainty of fixed rates, helping you to plan your budgets, without so much risk of being locked into a punishingly high rate. The deal runs for a fixed period of time, after which you revert to the normal variable rate. As with fixed- rate mortgages, expect to pay an arrangement fee for a capped mortgage and to face hefty early redemption penalties if you try to get out of a collared deal in the first few years. �Cashback deals With some standard variable- rate mortgages, you get a cash sum when you take out the mortgage. You can use the cash however you like, so it can be handy to put towards the costs of moving, decorating your new home, and so on. This can be a sizable sum: for example, 5 or 6 per cent of the amount you are borrowing. Although a cashback is not strictly speaking an interest- rate option, it is useful to look at it here because one use for the cashback would be to invest it to give you a sum to call on if your mortgage rate rises.

This would be well covered by a 5 per cent cashback deal, giving you a �2, 500 lump sum. For example, if you borrowed �50, 000 and the mortgage rate rose by 2 per cent over the first year of your mortgage, you could pay up to an extra �910 interest that year. After paying the extra interest you would still be in profit to the tune of �1, 59This looks a better option than, a one, say- year fixed- rate mortgage taken out at the same initial interest rate with an arrangement fee of �250, which would have saved you �910- �250= �66This is very simplified example. With cashback deals, there is usually and early redemption penalty period of five years or so. Real life is more complex and your sums will need to take into account the difference in interest rates between deals and longer time periods than one year. If you pay part or all of the mortgage during that time, you generally have to pay back the cashback you received. For example, you could borrow part of your mortgage at a variable rate and part at a fixed rate.

Some mortgage lenders let you mix- and- match different interest- rate options. Compared with taking out the whole mortgage on a fixed- interest basis, you would gain some benefit if interest rates fall, conversely, though, you would suffer some increase if interest rates rose. So mixing- and- matching is a way of hedging your bets. Compared with taking out the whole mortgage at a variable rate, you would face a smaller increase in payments if interest rates rose but also a smaller decrease if interest rates fell.