Which kind of mortgage makes more sense in the current environment?
With interest rates tumbling, variable rate mortgages are coming into their own and existing borrowers are seeing their monthly repayments plummet.
Of course, how much you will benefit depends on which lender you are with, and whether you are on a discounted variable rate or a tracker.
What's the difference?
A discounted variable rate is linked to your lender's standard variable rate (SVR). For example, it might be a 1% discount from SVR. It rises and falls in line with the SVR which usually reflects (but does not mirror) the Bank of England Base Rate. The lender is under no obligation to ensure its SVR follows Base Rate movements, though they usually do.
A tracker rate is linked directly to the Base Rate, for example at a margin of 1%, and it therefore mirrors Base Rate movements. The lender has to automatically pass on any movements in Base Rate, usually within one month.
So, given its transparency, surely a tracker is better in a falling interest rate environment?
Tracker pros and cons
Well, the third of existing borrowers on a tracker have certainly benefitted from rates having been cut from 5% to 3% in the last two months. On average they have seen their monthly payments reduce by around £166. And their lenders have not been able to 'um' and 'ah' over whether to pass on the cuts. That's the beauty of a tracker. No ifs, no buts.
Except for the big fat caveat that has emerged in recent weeks. That's the 'collar' that prevents trackers going below a certain level.
Collars mean that a mortgage rate cannot fall too far, no matter what happens to Base Rate. Nobody talked about them in the past, as they were buried in the small print of contracts and unlikely to come into play. But now that rates are tumbling, collars have been invoked and that stops tracker borrowers benefitting from future falls.
Even if rates fall to 0% (which is not beyond the realms of possibility), borrowers on a Halifax tracker may still have to pay 3% because of its collar. In other words they protect the lender from mortgage rates dropping too low.
Many lenders have collars at 3% leading some to predict the end of trackers as we know them, since they are no longer doing what are supposed to do if they cannot track Base Rate down.
It seems that trackers may have gone as low as they can go.
What about discounts?
Those on a discounted variable rate do not have the same certainty as tracker borrowers that Base Rate movements will be passed on in full, since they are linked to SVR.
This can actually be a benefit in a rising rate environment when some lenders look to gain a competitive advantage by not passing on all of a rise. However, in the current market the opposite is true and many lenders have not passed on all of the last two cuts in rate.
When the Base Rate was cut by 0.5% in October around half of lenders cut their SVR and of those many passed only a portion of the cut. HSBC for example didn't pass on any of the cut and Northern Rock passed on only 0.15%.
It will take another week or so before it is clear which lenders have passed on last week's massive 1.5% rate cut. C&G, Lloyd's TSB, Halifax, Abbey, Nationwide and RBS have already bowed to political pressure and passed on the full cut - a boon for those on SVR and on discounted variable rates who will see their mortgage rate fall. For example, Nationwide's standard variable rate is now just 4.69%.
But it is likely that many lenders will not be able to pass on the full 1.5% as their borrowing costs are currently much higher than the 3% Base Rate. Over 30 lenders still haven't announced what they will do.
Rather than having a clear collar, discounted variable rates therefore have an `effective' collar in that lenders simply cannot keep passing on rate cuts. Discounted rates can only move downwards if SVRs do - and many lenders have already said they cannot decrease their SVR further until borrowing costs reduce.
What next?
For new borrowers or those looking to remortgage, virtually all of the trackers on the market were pulled by lenders last week. The coming few weeks will see them repriced and relaunched but expect the margins to be higher than they were previously. If you want a tracker rate you choice is either HBSC's attractive 3.99% term tracker or nothing. And that is only available to those with a 40% deposit.
Discounted rates are also few and far between - HSBC pulled its 5.29% lifetime discount last week for example and discounted deals are difficult to find. Plus those still being advertised are hard to assess. Market Harborough Building Society offers a discounted rate of 5.95%, but this is based on a 1.2% discount from its 7.15% SVR, and it has not yet announced whether it will be passing on the rate cut.
Until lenders announce their intentions it is hard for borrowers to work out which deals are the most attractive. But this time next week will be a whole different story.