Variable rate mortgages
Taking out a tracker mortgage is essentially a gamble; you are guessing if the Bank of England (BOE) base rate will drop, rise, or stay as it is.
If you take out a tracker mortgage, your monthly repayments are linked to the base rate and will change when it moves up or down. Usually, the tracker is the base rate added to a percentage of between 1% and 4%. For instance, if your mortgage is base rate plus 2%, and the base rate is at 1% you will be paying an interest rate of 3%.
Most tracker mortgages are linked to the BOE base rate, though there are some that instead track LIBOR (the London Interbank Offered Rate), which is the commercial interest rate at which banks lend to each other.
Many people don't like the uncertainty that comes with having a tracker mortgage and opt instead for a fixed-rate mortgage, which means payments are the same amount each month. In comparison, tracker mortgage repayments can quickly change as base rate changes are usually applied within a month, so they are not a good option if you're trying to stick to a budget.
But tracker mortgages tend to offer better starting interest rates than fixed-rate mortgages to make the tracker a tempting option for borrowers. And with interest rates currently so low, tracker mortgages can save you a lot of money.
Best of both worlds
Some lenders even offer the best of both worlds by offering mortgages that track the base-rate for a specified amount of time and then switches to a (higher) fixed-rate for a remaining time period. However, you should do your sums carefully before thinking this really is the best of both worlds. In some cases this option can work out as more expensive than opting solely for either a tracker or fixed-rate – especially if interest rates move during the time of the tracker.
Borrowing £270,000 over a 25 year period on five year mortgages.
A tracker mortgage (+2.99% above base rate) would charge 3.49% when the base rate is at 0.5%.
A monthly repayment at this rate is £1,350. If the base rate didn't change, over five years you would pay approximately £81,000
A fixed rate mortgage for five years at a rate of 4.19% would translate into monthly repayments of £1,454. Over five years you would pay approximately £87,240
A combination of tracker and fix might track at the above rate, resulting in two years of repayments of £1,350 at a rate of 3.49%, if there was no movement in the base rate. You might then switch to a higher fix of 4.89%, making repayments for the last three years of £1,561. After five years you would have paid approximately £88,596, making this option more expensive than either a fix or a tracker.
When thinking about a tracker mortgage you should do sums, similar to those above, and compare the best tracker rate with the best fixed-rate over the mortgage period you are looking at. Work out how much of a base rate rise it would take for the tracker to become more expensive than the fix.
For instance, using the example above, a base rate at 1% would mean that the tracker rate would rise to 3.99%; still cheaper than the fixed-rate. However, a base rate of 1.5% or higher would make the tracker more expensive than the fixed-rate.
What is the Bank of England base rate going to do?
This is the million dollar question. Each month the Bank of England's Monetary Policy Committee meets to decide what the base rate will be set at. A complex mix of politics and economics affect interest rate changes. In recent years, the base rate has been at record lows, which means people who gambled on a tracker mortgage have had a good deal.
Some economists have said the low interest rates are here to stay for the next couple of years – if this is the case, it could mean tracker mortgages will be a better option. But no one can really know what it's going to do; economists frequently get it wrong!
Can I change from a tracker to a fixed-rate if the base rate rises?
On a standard tracker mortgage, you can't usually switch to a better deal until your current deal ends without paying an early repayment charge. These charges can be high. For example, on a five-year deal, you might have to pay 3% of the outstanding mortgage. If your mortgage was £150,000, this would be £4,500.
If you are thinking about a tracker mortgage, you should work out how much of a rate rise you can realistically afford. If you wouldn't be able to meet a significant rise, you should give more thought to a fixed-rate mortgage or choose a tracker that allows you to move from a tracker to a fix without any exit or early repayment fees. The rates on these mortgages may, or may not, be as competitive as other tracker mortgages that don't give you the option. But what's important is knowing that you won't be tied on to a mortgage rate that you could potentially find it difficult to afford.
Capped rate mortgages
Another alternative is a capped rate mortgage. These can be seen as a compromise between a tracker and a fixed-rate mortgage. As with a tracker, the interest rate changes on these products, but the cap gives a degree of certainty experienced with fixed-rate deals as the rate won't rise above certain level. This is particularly useful if interest rates rise in the near future. Capped rate mortgages can be good options for those who are able to afford only a small increase in monthly mortgage repayments.
Capped rate mortgage products also often come with a collar which means that the rate can't fall below a certain level either.
The interest rate on capped mortgages could link to the Bank of England base rate, or the lender's Standard Variable Rate.
Capped rate mortgages tend to be a niche product these days and are not widely available. A mortgage adviser may be able to give you a best view of the market and point out the lenders specialising in this area.
Caps can change
While a cap can offer peace of mind they are not water-tight; lenders can and do increase their cap limits. If the lender does want to increase the cap though, it must give you at least one month's notice. It should also give a three-month period where you won't be penalised with early repayment or exit charges if you decide to switch your mortgage as a result of the change in cap.
- Only choose a tracker if you can afford for your repayments to rise
- Check if there is a fee for getting out of your deal early
- Some mortgages allow you to choose a tracker followed by a fixed-rate
If you choose a tracker mortgage, make sure you start a separate pot of savings to soften the blow if rates rise