Introduction
The product with the most competitive rate is not necessarily the best mortgage
for you. There are quite a number of other factors that may come into consideration
when you are making your choice.
While the rate may ultimately be the overriding factor that sways your decision,
you should at least familiarise yourself with the other aspects of your chosen product,
to make sure you are not blindsided by some unexpected cost or restriction.
Comparing Rates
Here are some of the main points to bear in mind when comparing mortgage rates:
Variable and discounted rates
The variable rate mortgage is the traditional and most widely available product,
with many variable rates being discounted fo a period of time before reverting to
the standard variable rate. The level of repayment varies with the general level
of interest rates, which can make this type of rate a little unpredictable. The
main advantage is that borrowers know that they are unlikely to be paying more than
the prevailing rate.
Fixed rates
The fixed rate mortgage has the advantage that the borrower can predict the exact
level of repayments for the time they are fixed. A fixed rate mortgage could be
cheap if rates rise although, when it expires, the switch to variable rates could
come as a shock. If interest rates drop substantially, the fixed rate might turn
out to be uneconomic and early redemption could be relatively expensive.
Capped rates
The 'collar and cap' or just a capped mortgage could turn out to be an attractive
compromise for many borrowers because it limits the maximum levels of payment if
interest rates rise. But the verdict in each case will depend on the terms offered.
APR & IRR
Comparing the rates that the lenders charge is not that easy, unless you have a
good grounding in mathematics. Even with relatively simple products, it's not that
easy, never mind trying to compare the complex interest calculations on a stepped
discount mortgage and a collared cashback mortgage, for instance. To make matters
worse, some lenders calculate interest daily and others yearly, which can have a
huge impact on the amount you pay back over the life of the loan.
APR goes some way to alleviate this problem. This is the indicator that lenders
are required by the Consumer Credit Act to provide, in order to allow borrowers
to compare the cost of different loan products. It takes into account the costs
involved in setting up the mortgage, any discount periods, how often interest is
calculated and calculates what the average rate of interest will be over the life
of the loan.
Flaws of the Annual Percentage Rate measure (APR)
The average length of time people keep their mortgage for is said to be around seven
years. Whether it's because they sell their house or opt for a remortgage, there
are relatively few people who keep exactly the same mortgage until it is fully paid
off. This means that comparing the total cost of mortgage repayments over twenty-five
years is not necessarily all that realistic.
Using APR to compare mortgages flattens out some differences that are more striking
over a shorter period of time. Take a look at this example:
- There are two mortgages, A and B.
- Mortgage A is extremely heavily discounted for five years. After that, it reverts
to a rate that is well over and above the general level of rates in the market,
as the lender relies on you to stay loyal while they recoup the cost of offering
such an attractive discount.
- Mortgage B is slightly discounted for three years, but then reverts to a rate that
is very competitive as standard variable rates go.
- Which mortgage do you choose?
If you compare solely based on APR, mortgage B is likely to come out top, assuming
that the other associated charges are similar for both products. Over the twenty
five years, the competitive standard variable rate which is offered for the bulk
of the life of the loan will probably outweigh the heavy early discount of mortgage
A. However, if were you change your mortgage after 7 years, you would probably have
been better off with mortgage A as you would have been enjoying a strong discount
for most of the time you were making your repayments, while only going on to pay
the higher rate of interest for a short period of time.
Another point to bear in mind is that APR offers a snapshot of what the average
rate you pay over the life of the loan would be if interest rates stayed the same
for the whole term of the mortgage. APR cannot make allowances for changes in interest
rate and the effect that will have on different mortgage products. If rates change
(as is almost certain) during the discount, capped or fixed period, then the APR
will instantly become inaccurate. Consider this:
- Two mortgages have exactly the same APR. One is a 5-year fixed rate mortgage, the
other is a base rate tracker. General levels of interest rates rise and rise for
the five years after the mortgages are bought, then suddenly drop to their original
level and stay there for twenty years.
- Looking back after twenty five years, the APR that was originally quoted for the
fixed rate mortgage will prove to have been exactly right, since the rate payable
remained fixed throughout the period of rising interest rates. But the total repayments
and therefore the APR on the base rate tracker mortgage would have ended up being
higher than that indicated at the outset, since payments would have increased in
line with interest rate rises over the first five years. In reality the two mortgages
that quoted the same APR could have ended up with very different levels of overall
repayments.
Although this exact scenario is never likely to happen, it does highlight the fact
that APR is not necessarily a perfect measure of what your repayments are going
to be.
Internal Rate of Return (IRR)
The Internal Rate of Return is not a term that most people will be familiar with,
as it is not usually quoted by lenders.
IRR is largely the same as APR, in as much that it offers a way of measuring the
total annual costs of a mortgage loan. Like APR, it also takes into account any
additional fees and costs that are incorporated into your payments, as well as any
introductory offers, and factors these in to give an average annual rate of interest
payable over a period of time.
Although it is still an imperfect measure due to the impossibility of incorporating
future changes in interest rates into the calculation, it does have one key point
in its favour over APR as a measure for assessing mortgage products. For any product,
the Internal Rate of Return can be calculated over any period of time that you like.
This means you can use a calculator like the one on this site to compare the averaged
out repayments over any period of time that you like, therefore allowing you to
assess which mortgage would be better value in a variety of circumstances that may
occur in future. It also allows you to factor in any redemption penalties that would
be payable within the period that you have chosen as the likely term of the mortgage.
Both APR and the Internal Rate of Return are useful measures for an initial comparison
of mortgage products, but you should always look at the bigger picture and consider
the rest of the product features and any other factors that may influence your decision.