Watch Out For This Mortgage Blunder

Early repayment charges can be a huge price to pay for changing your mind. Here's what to look out for.

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If you're taking out a mortgage this summer, you'll want to make absolutely sure you get the best deal you can.

But that can be tricky as there are many hidden nasties to avoid these days. So, in today's Summer Lolly, I'm going to look at one baddie in particular: Early Repayment Charges (ERCs).

What is an ERC?

ERCs are also known as redemption penalties. They normally apply when you take out a fixed, discount or tracker mortgage deal for a set length of time, and then decide to remortgage/pay off the mortgage before the deal ends. Effectively, it's a penalty you pay for changing your mind - and it can cost you thousands and thousands of pounds.

Say you go for a mortgage which is fixed for the next five years. The ERC will usually last as long as the fixed rate lasts, so -- in this case -- it will apply for the next five years.

What if, at some point during those five years, you decide you want to:

 Sell up and get off the housing ladder
 Remortgage to a better deal
 Overpay your mortgage
 Pay off the entire mortgage early (of course, you might not care about the ERC if you have the means to be mortgage-free!)

All these circumstances will cause the ERC to rear its ugly head.

How much does it cost?

The cost can be substantial -- typically around 3% of your mortgage advance (the original amount you borrowed), although this does vary from deal to deal. Sometimes it will be around 3% of your outstanding balance, or 3% of the sum you have already paid. The latter is usually the cheapest by far.

Here's how the figures stack up for each of these options if you originally borrowed £150,000 and have paid off £10,000 at the point you incur the ERC:

As you can see, in this situation, you could be charged an ERC of up to £4,500 to get out early. That's obviously a huge incentive to stay put until the penalty no longer applies.

What if you want to move house? Luckily, most decent mortgage deals nowadays are portable, so you may not need to pay an ERC to move the mortgage to a new property, because you are staying with the same lender.

With some mortgage deals, the ERC will gradually reduce over the period it applies. For instance, over a five-year period, a reducing ERC may be set at 5% in Year One but reduce to 1% by Year Five. In this way, reducing ERCs are preferable to those which are fixed at the same level throughout.

Of course, if you don't need to change your current mortgage deal at any point, you wouldn't normally give the ERC a second thought.

Extended ERCs

It might not seem unreasonable to compel borrowers to stick with the same lender for the length of a deal which offers a competitive rate. But what I have a particular gripe over is ERCs which extend beyond the competitive introductory period.

For example, Norwich & Peterborough Building Society is offering one-year and two-year fixed rate mortgages with ERCs that apply for three years. When the fixed rate deal finishes in 2009 or 2010, you will automatically move onto a Base Rate tracker, currently at an uncompetitive 6.65%. But if you want to move off this rate before 2011, the lender will charge you 5% of your outstanding loan as a penalty.

This is unfortunate since Norwich & Peterborough offer pretty attractive mortgage rates. But borrowers are effectively held to ransom during the period between the fixed rate coming to an end and the ERC disappearing. And because the Base Rate is variable, it's possible that the new rate you are forced onto will be higher than your original fixed rate.

What if you can't afford this higher rate? You will have no choice but to pay the hefty ERC. So I would suggest you think twice about taking any mortgage where there is an extended tie-in. It could be a costly mistake.

Not competitive

Beware of ERCs on uncompetitive variable rate mortgages! Sometimes, ERCs appear on variable rate deals where there is no competitive introductory rate at all. Yorkshire Bank and several building societies including Manchester and Newcastle apply ERCs to their standard variable rate mortgages. So watch out for those deals.

What if the unexpected happens?

Nothing is certain in life -- other than the proverbial death and taxes! Prepare for the unexpected because you may need to get out of your mortgage early even if there is an ERC.

I should know. In 2004, I took out a five-year fixed rate mortgage on my first home, but unfortunately, two years later I had no choice but to sell up. Because it was still within the fixed-rate period, I had to pay a costly ERC of 3%.

Unfortunately, this tends to happen more frequently than you might imagine. But at least, forewarned is forearmed. So -- before you take the plunge -- please have a serious think about how long you want to be tied-in to your mortgage and avoid extended ERCs like the plague.

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