A 5-year fixed rate mortgage will save you money

We explain why five-year fixed mortgage deals are looking a lot better than two-year fixes, despite the higher initial cost.

The favourite mortgage of the Brit mortgage borrower, the two-year fixed rate, is back in vogue. After a period on the shelf, they are back as by far the most popular fixes at the moment and the most recommended by brokers and commentators.

However, while they are cheap, are they a better option than going for a five-year fixed rate mortgage?

I searched for the best mortgage deals using lovemoney.com's innovative mortgage tool and providers' websites to create my test, based on a £170,000 property with a £144,000, 25-year mortgage.* (That's a £26,000 deposit, so a loan-to-value just under 85%.)

Cost comparison after five years

Let's compare the total cost over five years of the two deals. I'll assume that, if you take a two-year fix now, you'll remortgage in 2012 to a three-year deal and a 23-year mortgage (because two years will have passed). The following table shows what the total bill might be after five years depending on interest rates:

2-year fixed deal, followed by 3-year re-mortgage

Some of my assumptions are conservative, meaning the figures for the two-year deals might be on the low side.

Which is better?

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The costs to someone taking a two-year fix vary depending on what happens to interest rates. However, when you take into account the total you've paid plus the outstanding mortgage debt, the five-year deal leaves you £4,800 better off if interest rates rise by a mere two percentage points. Also, since your total outstanding debt is lower, you'll have the prospect of lower interest bills in future.

What's more, a two percentage-point increase will see your monthly payments climb to £80pm more than the five-year fix. If rates went up six percentage points your monthly repayments would be £450pm higher.

What about overpaying?

If you go for the cheaper two-year deal you could overpay on your mortgage each month, using some of the money you are saving thanks to the lower initial rate. This will reduce your mortgage faster, as well as reduce the interest you pay in the long run.

The difference between your initial repayments if you chose a two-year mortgage instead of a five-year one is £108pm. Here's how overpaying that much might leave you better off after five years:

As above, with overpayments

?If interest rates remain unchanged in two years, the minimum repayment will remain low, so you might decide to continue making overpayments. This row reflects that.

So, should we overpay?

Forget the five-year deal for a moment and let's just compare overpaying with not overpaying. Remember, the first table shows what might happen if you go for a two-year deal today, and the second shows what might happen if you get that same two-year deal but choose to overpay.

Look at the second columns of both the above tables (headed 'Total paid'). Notice that the total amount of money you've had to pay over the five years has gone up when you make overpayments by maybe £2,000.

Look now at the fourth column of both tables ('Monthly payments after two years'). If you've made overpayments, after two years your monthly repayments don't go up by quite as much, saving you around £15-£35pm.

However, it's the third? column (headed 'Mortgage balance outstanding') that in my view is the most interesting. As you can see from the two tables, if you overpay you'll reduce your mortgage debt by an extra £2,500 to £5,000, which will shave months off your mortgage and help keep your payments lower for the remainder of it.

It's not a straightforward decision to overpay

That's all great, but you would need to be sure you can afford the higher monthly repayments if rates were to rise within two years. If you've been overpaying rather than putting money aside, you might find that difficult, in which case you you'll need to keep some money back in savings.

There are other things you could do with that money too, such as invest in shares or get some training to improve your earnings. Another positive for overpaying is it's flexible: you can reduce or increase overpayments as you need. On the other hand, not all mortgages let you overpay.

All in all, it's not a straightforward decision.

Recent question on this topic

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Two years with overpayments versus five-year deals

Now let's turn to whether two-year deals with overpayments are better than five-year deals.

By my calculations, if you can overpay on two-year deals, you'll still be worse off than with a five-year deal by £4,100 if rates rise just two percentage points. If they rise more you'll be even worse off. Plus you face the prospect of paying more interest in the future, because your outstanding debt will be higher.

All in all, five-year deals look overwhelmingly better to me.

Every time: it's personal

However, you must consider your own circumstances, such as if you're planning to sell inside five years and how short your mortgage is. If your mortgage is smaller you may be able to more easily bear the risk of overpaying. What's more, a different-sized deposit might make two-year deals more attractive, although I expect the difference between the two deals must be large for that to happen.

Deals you can get may be worse or have a different balance between interest rates and fees, too, which can also change things.

Finally, in two years you might find that a tracker deal, rather than a fix, is better and cheaper, and you might think it'll save you money, so it's not a straightforward decision if you're looking to guess the direction of interest rates.

Five-year 85% LTV deal on a 25-year mortgage with the Post Office: 5.45% fixed + £665 in fees + £1,000 in fees added to mortgage. That's £886pm and £53,831 in total after five years, including all fees and monthly payments. After five years the mortgage balance is reduced to £129,345 and the interest paid is £37,512.

Two-year 85% LTV deal on a 25-year mortgage with Cheltenham & Gloucester: 3.99% fixed + £135 in fees + 2.5% in fees added to mortgage. That's £778pm and £18,813 in total after two years, including fees and monthly payments. After two years the mortgage balance is reduced to £140,430 and the interest paid is £11,508.

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