Topic 23 - Interest-rate options (UNIT 6) Flashcards
There are multiple ways repay a mortgage. True or false
False, there are only 2 ways. Interest only and capital repayment
There are a wide variety of mortgage products available though with different interest rate options
What are the ways interest can be applied to a mortgage?
Annual rest, Monthly rest and Daily rest
NOTE. THERE ARE MANY DIFFERENT PRODUCTS. THIS TOPIC INCLUDES THE MAIN ONES BUT IS NOT THE FULL LIST
Tell me the main mortgage products
-standard variable‑rate products;
-discounted‑rate products;
-tracker products;
-fixed‑rate products;
-capped‑rate products;
-flexible and offset products
Tell me about the standard variable rate (SVR) mortgage
Where the interest rate varies with market rates
How it works: The base rate increases. This results in the lender increasing their respective SVR. This results in higher payments for the borrower, and vice versa
Used to be very common but not so anymore
Lenders have often been criticised for increasing the SVR quickly when Bank rate rises, but taking too long to reduce it when Bank rate is reduced
What are the benefits of a standard variable rate mortgage?
What are the negatives of a standard variable rate mortgage?
Benefits:
Generally no early repayment charges
They tend to have lower product fees than fixed‑rate or capped‑rate mortgages
Negatives: Variable‑rate mortgages do not usually offer a portability option
Can be difficult to plan household budgets, especially when markets are volatile
Tell me about the discounted-rate mortgage
It simply offers a discount from the lender’s standard variable rate (SVR) for a given period and is designed to attract new mortgage business, in the same way as
a fixed‑rate product
So, if the lender’s SVR is 4% and the discount offered is 1% for two years, the borrower will pay 3% initially. If the lender’s SVR increases or decreases during the discount term, the borrower will still pay 1% below the SVR.
Some discounted mortgage products offer a stepped discount. What is this?
Applies the same rules as a discounted rate mortgage but the discount may be 1.0 per cent in the first year, 1.25 per cent in the second year and 1.5 per cent in the third year for example
What are the benefits and negatives of discounted rate mortgages
Benefits:
A cheaper way to borrow than a standard variable rate mortgage
Negatives:
Has Early repayment charges to deter part or full redemption of the loan during the discounted period
There is a minimum interest rate that can be reached ( known as an ‘interest rate floor’)
If an arrangement fee for the loan applies it is generally non refundable
Loan may be subject to compulsory purchase of an associated product, eg buildings and
contents insurance,
Although better than the SVR mortgage, it can still be difficult to budget in a volatile market
Tell me about tracker mortgages
Give an example of how it works
Tracker mortgages are variable‑rate mortgages that follow (or track) a stated interest‑rate benchmark. Commonly this would be the Bank Of England’s Base Rate. Some tracker mortgages are based on the SONIA rate too
Example of how it work: The tracker mortgage may be for a period of 5 years (note, some lenders offer lifetime trackers) During that period, the interest rate on the mortgage is set at a percentage rate above or below the base rate. For example, a base‑rate tracker
set at 2 per cent above base rate will follow the base rate but will always be 2% above it. A base‑rate tracker set at 1 per cent below base rate will follow the base rate but will be 1% below it.
Tell me the benefits and negatives of a tracker mortgage
Advantage:
Overpayments or lump sum
payments are allowed without penalty within specified limits – typically up to 10% per year.
Usually a cheaper way to borrow than the lenders SVR SVR because the Bank of England base rate is usually lower than the average lender’s SVR
Disadvantages:
Product fee
Application fee – to cover the lender’s application processing costs
Early repayment charge – on full or part redemption within a specified
period
Compulsory purchase of associated products (ie buildings/contents cover
What event led to lenders introducing a collar rate for their tracker mortgages?
Collar rate just means a minimum rate
In 2009, the base rate fell to 1%. Many borrowers
had trackers set at 1% or even 2% below the base rate, which could, in theory, have led to the lender paying the borrower because the tracker rate could be minus 1%
Lenders therefore introduced the collar rate so they didn’t have the same issue again
Some tracker mortgages (generally commercial and subprime mortgages) used to be based on LIBOR. What happened to these products after LIBOR was replaced by SONIA?
With the announcement that Libor would be replaced by Sonia as the benchmark for UK financial markets by the end of 2021, the FCA and the Bank of England stopped the use of Libor for new mortgages from
the third quarter of 2020, and existing mortgages changed to the reference point when Sonia became the benchmark.
Realistically, lenders have three alternatives to Libor: the BOE base rate, a rate derived from Sonia or fixed rates
Tell me about fixed rate mortgage products
With a fixed‑rate mortgage, the rate of interest (and so the monthly payment) is fixed for an agreed period, typically between one and five years, but sometimes
as long as ten years.
At the end of the fixed‑rate term, the rate normally moves to the lender’s standard variable rate (SVR), known as the ‘reversion’ rate
What is the reversion rate?
The lenders SVR
How do lenders raise funds for its fixed rate mortgages and how does a lender figure out the rate it will offer?
The rate at which interest is charged is linked to the rate paid by the lender on funds raised on the wholesale money markets by the lender
If a lender raises £100m from the market at a
fixed rate of 3 per cent over a five‑year period, then this amount will be made available to new borrowers in the form of five‑year fixed‑rate mortgages. The lender will charge a higher rate to borrowers (its premium) to cover its costs and make a profit – for
example, it might offer mortgages at between 4 and 4.5 per cent.
Once the £100m has been lent, the product will be withdrawn, and possibly replaced with a new product at an interest rate linked to the prevailing money market rates at that time
This is why fixed products have early repayment charges. It is because the lender has borrowed funds for a set time at a set rate and if you redeem the mortgage early or change products it will mean the lender will not receive its interest so will take a loss on the money it has borrowed on the wholesale market. The ERC pays for this shortfall. The early repayment charge is to allow the lender to recover
some of its losses on cancelling the fixed‑rate deal. The funds would have to be lent to another borrower, possibly at a lower rate of interest, and the lender’s profit margin would be reduced
What are the benefits and negatives of a fixed rate mortgage?
Benefits:
- Easy to budget
- In times of increasing rates it will protect the borrower
- Can allow overpayments up to a certain amount each year, as specified by the lender (typically 10%)
Has PORTABILITY OPTIONs
Negatives:
- In times of decreasing rates the borrower will not benefit
- If rates rise nearing the fixed period coming to an end it could lead to a substantial increase in monthly repayments
- Non refundable product fees and application fees
- Early repayment charges ( This can even apply
beyond the end of the fixed‑rate period. These are known as ‘overhang’ penalties but are now rarely found, although they are not banned) - Associated purchases (some lenders will require additional products to be purchased such as buildings/ contents insurance or mortgage payment protection)
If a mortgage product has a portability option what does this mean?
Many fixed‑rate and ‘special deal’ mortgages feature a
portability option.
This allows the borrower to take the existing
arrangement to a new property without incurring an early repayment charge. The existing rate can be transferred to a new property for the same amount and the same remaining term as on the previous property.
If the borrower needs a larger mortgage, the excess will be on whatever product the lender offers at that point and, if the borrower requires a smaller mortgage, there is likely to be an early repayment charge on the difference between the old and new amount.
The lender also needs to ensure the new arrangement is affordable and meets its current lending policy.
What is a capped‑rate mortgage?
The capped‑rate mortgage varies with the lender’s SVR, up to a pre-set cap (or maximum). If the SVR is reduced, the rate the borrower pays is reduced.
If the SVR moves above the cap, the borrower pays the capped rate.
In other words, there is a limit (cap) on the rate the borrower pays.
Who are capped rate mortgages for?
A capped‑rate mortgage is suitable for somebody who feels that interest rates are about to rise and wants the security of knowing the maximum they will
have to pay each month, but would like to benefit if rates drop. Other points to consider are as follows
What are the advantages/disadvantages of a capped rate mortgage?
Advantages:
You will be protected against interest rate increases but can also benefit from a fall
As with fixed‑rate mortgages, lender may allow charge‑free overpayments or single repayments within specified limits.
Most capped‑rate mortgages offer a portability option
Disadvantages:
There is likely to be an application and/or product fee.
There will probably be an early repayment charge on redemption during the capped period.
The lender has set an interest rate cap for your mortgage
The lender has set an interest rate collar for your mortgage
What do both mean?
1 = they have set a higher limit it cannot exceed
2 = they have set a lower limit it cannot fall under
NOTE: This is why mortgages with both a lower limit and higher limit are known as ‘capped and collar’ mortgages.
A mortgage with a 5.5 per cent cap and a 2.5 per cent collar will allow the rate to vary within those limits, but if rates were to go above 5.5 per cent, the borrower would pay 5.5 per cent, and if they were to drop below 2.5 per cent, they would pay 2.5 per cent
What is a flexible mortgage?
There is no specific definition of a ‘flexible mortgage’ as such, but it is generally accepted that it will have the following basic features which are:
Daily interest calculation;
The facility to make overpayments, within specified limits, at any time without incurring a penalty;
The facility to underpay (lower than normal monthly payments) if the borrower’s circumstances warrant it;
The facility to take a payment holiday, again if circumstances warrant it;
The mortgage arrangement can be transferred to another property without penalties;
Most flexible mortgages offer an offset facility
Some flexible mortgages also offer a ‘payback’ facility
What is this?
where the borrower can take back any overpayments they have made in the past.
Some lenders offer a ‘drawdown’ facility on their flexible mortgages. What is this?
A maximum borrowing amount is agreed at the start, typically 75 per cent of the initial property value;
The borrower takes initial borrowing below the maximum limit;
The borrower can drawdown additional funds from the account as and when they wish, providing total borrowing doesn’t exceed the agreed limit.
What feature of some flexible mortgages allow the borrower to ‘borrow back’ money they repaid from the original loan amount
A drawdown’ facility
What is an offset mortgage?
Where the account holder’s mortgage and savings are held in linked accounts.
The savings held in the linked savings account are offset against the mortgage account, which means that mortgage interest is only charged on the
balance.
For example:
,Mortgage of 150k without offset mortgage at 10%. Mortgage interest is 15k
Same mortgage but offset with savings account with balance of 50k. Mortgage interest would be 10% of 100k which is 10k.
The savings are not tied into the mortgage account and can be taken out at any time without notice or penalties
What are the benefits/negatives of an offset mortgage?
Advantage:
High flexibility
Those who can maintain a significant and consistent level of savings in the arrangement will save far more than in a conventional savings account
Disadvantage:
The interest rate charged will likely be slightly higher than the lender’s SVR
Early repayment charges likely
Some products may incorporate a product fee
May be required to purchase an associated product
Complicated (ie, fixed interest is far more easy to understand for the typical borrower)
One difference between a standard variable-rate mortgage and a fixed-rate mortgage is that:
A) Variable-rate mortgages are less likely to feature early repayment charges.
b) fixed-rate mortgages charge a lower arrangement fee.
C) only fixed-rate mortgages offer a portability option.
A
Lower arrangement fees are usually charged for variable-rate mortgages. Both variable-rate and fixed-rate mortgages can offer a portability option
As a result of an increase of 0.5% in Bank rate, Sam’s lender has increased its standard variable rate by 1% but Sam’s mortgage has only increased by 0.3%. This is because Sam has a:
A) tracker mortgage.
B) discounted-rate mortgage.
C) capped-rate mortgage.
C
A tracker mortgage moves in line with the Bank/Base rate, so would increase by 0.5%. A discounted-rate mortgage gives a discount from the lender’s standard variable rate, so the increase would be 1%. A capped-rate mortgage sets a cap to limit the maximum rate that would apply. In this case the cap is 0.3% above the rate Sam was paying, limiting his increase to 0.3%.
What tends to happen when fixed-rate mortgage rates are low?
a) Lenders tend not to offer capped-rate mortgages.
b) New capped-rate mortgages include a collar.
c) Arrangement fees on capped-rate mortgages reduce
A
When fixed-rate mortgage rates are low, there is little point taking out a capped-rate mortgage, so lenders tend not to offer them until rates increase
Karen and Darren have a flexible mortgage with their bank. Which of the following terms is most likely to apply?
A) Interest calculated on a monthly rest basis.
B) The right to draw down further amounts, up to an agreed limit, without a further affordability assessment.
C) The right to take payment holidays, subject to certain conditions
c
With flexible mortgages interest is calculated on a daily rest basis. MCOB responsible lending rules require an affordability assessment before withdrawal of any further funds. Payment holidays would be permitted, subject to the presence of past overpayments and sufficient credit in the account
Trish has an offset mortgage on a capital repayment basis. Keeping a consistent level of savings in the linked account would:
A) reduce the term of her mortgage.
B) result in a lower interest rate on the mortgage account.
C) reduce the income tax payable on her savings
A
As Trish’s monthly repayments would normally stay the same, the savings would reduce the amount of interest charged, which would in turn mean repayment of more capital each month. This would result in the capital being paid off more quickly and a shorter term. The savings would have no effect on the actual interest rate charged. No interest would be paid on her savings, so income tax would not be relevant
Bob and Luka have an offset mortgage with an outstanding balance of £120,000 and a current interest rate of 4%. They have no savings linked to the mortgage at the moment but they do have £20,000 in an investment account with a local building society, earning 2% gross. Their financial adviser has suggested that they move their savings into a linked offset account. Should they?
Definitely not.
They should seriously consider it.
Definitely yes
B OR C
Bob and Luka should seriously consider taking their financial adviser’s advice. If they move the £20,000 into the offset account, they will pay mortgage interest on £100,000. This will save them £67 a month in interest (initially and increasing each month). This outweighs the loss of £33 per month gross on savings
ellen is considering a mortgage that offers a cashback facility. Which of the following is true? The cashback received:
A) will be subject to income tax.
b) may be clawed back if the mortgage is redeemed early.
c) will always be based on a percentage of the mortgage
B
Cashback is not subject to tax and could be a fixed amount or a percentage of the mortgage so not C
