When choosing a home loan, make sure that you're not seduced by headline-grabbing rates that come with a nasty sting in the tail.
Given that they can choose from thousands of different mortgages, how on earth can first-time buyers and home-movers find their ideal home loan? To be honest, this task is beyond most mere mortals, so it's best done by an experienced mortgage broker. In fact, almost two in three home loans are arranged via brokers, which indicates that the British public values their expertise.
Indeed, although I've worked in financial services for two decades, I wouldn't go hunting for a mortgage without employing the services of a no-fee broker. However, it's important to choose the right broker, as many charge steep fees for their advice. (Not so our award-winning mortgage service, which charges no broking fee and searches the entire mortgage market to find the best deals for Fools!)
At the very least, a broker can show you the very latest deals and warn you about the nasties which lurk in the small print. For example, brokers know that it's crucial to look beyond headline-grabbing interest rates in order to get a clear picture of what's really on offer. In particular, they know that the rate in display is only just the beginning, thanks to a bewildering array of additional fees, charges and penalties.
Today, I'd like to bring one drawback to your attention -- which always accompanies low-cost mortgages -- known as the early repayment charge (ERC). When you take out an attractive low-rate mortgage, it's quite likely that your mortgage lender could make a short-term loss on this cheap lending. Thus, in order to turn a profit from you, it will aim to lock you in over a longer period.
For example, if you go for, say, a five-year fixed-rate mortgage, then it's normal for an ERC to apply throughout all five years. In other words, if you pay off or move your mortgage during this early repayment period, then you'll be hit by a hefty fee.
When lenders offer incredibly attractive mortgage rates (say, fixed at under 5% for two years) then an early repayment period won't expire when a special-rate deal ends. In many cases, an ERC applies for the first five years. Thus, in this example, you'd be locked in for three more years after your two-year fix ends. In most cases, ERCs are so high that bailing out early will set you back thousands of pounds, which neatly prevents you from jumping ship.
The problem with these `extended ERCs' is that they are what I call "a short-term cherry/long-term lemon". That's because during the extended redemption period, you're tied in to a lender's standard variable rate (SVR), which is normally around 2% higher than the most competitive deals available on the market - so your rate jumps from less than 5% to around 7.75%. Hence, it's swings and roundabouts: what you gain in the early years, you lose in the later years!
In general, I recommend that Fools should avoid entering into mortgage deals which have a very low initial rate and a lengthy lock-in. This is because, on top of the extended ERC, there is a far higher risk of `payment shock' when the special-rate deal ends and the SVR kicks in. In some cases, this can cause mortgage repayments to double overnight, putting severe strain on a household's finances.
Then again, I see that the UK's leading mortgage lender, Halifax, has gone against the grain by launching two highly unusual fixed-rate mortgages this week. Here they are:
Type of loan | Rate (fixed until 28/02/13) | Upfront fee (£) | Early redemption charge |
|---|---|---|---|
Purchase | 5.99% | 699 | 4% to 28/02/09 3% to 28/02/10 2% to 28/02/11 |
Remortgage | 6.09% | 699 | 4% to 28/02/09 3% to 28/02/10 2% to 28/02/11 |
As you can see, these mortgages are identical, except that remortgagers pay an interest rate which is 0.1% a year higher than homebuyers pay. However, the really remarkable thing about these mortgages that the early repayment period ends two years before the mortgage does. In other words, although these are five-year fixed rates, the ERC only applies for the first three years.
This is the first short-term fixed-rate deal that I've seen which comes with an ERC-free period. Hence, I look forward to seeing yet more flexibility when it comes to ERCs and penalty-free periods. With any luck, the tide has turned and we'll see loans with extended lock-in periods becoming as rare as hen's teeth. I certainly hope so, because the very low interest rates which accompany mortgages with extended ERCs distort consumer perception about how low rates can go.
Finally, it's worth pointing out that there is a cost attached to this increased flexibility. That's because the above mortgages won't top the Best Buy tables based on their rates and fees. However, their get-out clause after three years makes them far more accommodating than comparable five-year fixes. Hence, they will undoubtedly win over customers who want the best of both worlds, which is no bad thing.
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