Save money by capping your mortgage

A new capped mortgage product has been launched, promising to save you money - but will it really?

How do you fancy protecting yourself from future Base Rate rises?

Mortgage broker John Charcol has developed a product it's calling Interest Rate Protector, which is effectively insurance against rising mortgage rates.

Normally we use fixed- or capped-rate mortgages to protect against interest rate rises. This new product allows you to keep your flexible mortgage – be it an SVR mortgage or a tracker. You pay a fee up front and in return you cap your mortgage payments at an agreed level.

To cap it all

Because of the legal structure of the product (for insiders, it's a derivatives contract, not insurance) your mortgages must total at least £500,000, although this can be spread across several mortgages if you have more than one property, which can be residential, commercial or buy-to-let. You can cap for a minimum of three years, but caps of five years or longer are available (and probably more advisable). What's more, you get to choose the level of the cap, so for example you might like to cap at your current mortgage rate plus 3%.

John Charcol believes you're more likely to benefit if you're on a cheap SVR or tracker, such as the 2.5% rate with Nationwide, Cheltenham & Gloucester or Lloyds. It could also be useful if you're unable to remortgage to a fixed rate due to lack of equity, because the price of this product is not affected by the loan to value (LTV).

The fee must be paid up front and varies with daily market conditions. In other words, when lenders think rising rates are more likely, the cap will cost more. At the time John Charcol announced this new product, it reported these rough costs for five-year caps:

Five-year cap with Interest Rate Protector

You've probably noticed the Interest Rate Protector is cheaper the larger your mortgage is. Also and unsurprisingly, the higher that you're willing to cap at, the lower the cost.

I've included the monthly cost in the above table to show how much it would work out at, but the entire fee has to be paid up front. To give you some rough numbers, here's how much you might pay when adding Interest Rate Protector's five-year cap to your mortgage, assuming you're currently paying 2.5% variable:

Cost of a 20-year mortgage at 2.5%

That was based on a long mortgage of 20 years, because you're less likely to want a cap if your mortgage is coming closer to its end.

How it compares with fixed deals

On a total cost basis (i.e. including fees and charges), looking at the best mortgages available (including Yorkshire Building Society's 5-year fix at 3.99%) Interest Rate Protector comes out well – if interest rates don't rise.

All fixed deals that I can find are more expensive – by at least £100pm – when compared to the figures above for John Charcol's capped product.

If interest rates rise

However, my figures above assume interest rates remain the same. By my reckoning, if rates were to go up about two percentage points inside two years, your five-year cap will probably end up costing you a bit more overall than a top fixed-rate mortgage.

Since protecting against rising interest rates is the point of this product, that's disappointing.

It could still have its uses

That said, my figures are based on a 75% LTV and that you're able to get the best fixed deals.

If you have less equity in your home (i.e. the LTV is higher) or your financial situation isn't so good, fixed-mortgage deals may be more expensive for you and the Interest Rate Protector becomes progressively more attractive.

On the other hand, if you're currently paying a variable rate somewhat higher than 2.5%, a fixed deal begins to look more attractive in comparison to this new capped product.

How it compares versus capped deals

You'd think it would be fairer to compare this product with capped mortgage deals, but it isn't at the moment. There are so few capped mortgages (when you discount duplicate products under different brand names there are two five-year caps that I can find for £500,000+ mortgages) that there's no competition and therefore the prices are high – higher than the cheapest fixed deals.

What if you move?

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You can take Interest Rate Protector when you move.

If you ever decide you don't need it any more, you can sell it, because it's a product capable of being bought and sold. You can't know what you'll be offered for it until you do, because the price you'll receive will largely depend on market conditions.

If, for example, the risk of interest rates rising has shrunk dramatically then you might get very little.

On the other hand, if rates have risen a fair bit faster than the industry is predicting then you could even sell at a profit. It'll depend what buyers are willing to pay.

Consider your options

Here are some possibilities to consider:

·     If you're on quite a high variable interest rate, you could see if it's possible to switch to a cheap tracker (such as ING's full-term tracker at 2.65%, £200 fee up front, £750 fee added to mortgage and no early redemption charge) in addition to Interest Rate Protector.

·     You could put the fee money into a high interest savings account or overpay your mortgage instead. The latter would reduce the total cost by thousands of pounds over five years, but you will still have the risk of higher interest rates.

Finally, John Charcol recommends you seek advice before taking out its product as there may be tax implications.

I think that for those of you with the time and energy, £500,000-worth of mortgages and a big pot of spare cash, it could be worth having a look how the price of this compares to your other mortgaging options, but its usefulness is going to be limited to a small number of borrowers.

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