Should I extend the term of my mortgage… or fix the rate?
I have a standard variable rate mortgage with an interest rate that goes up to 5.99% starting next month.
My loan is around £125,000 and I am 12 years into a 25 year term.
What is my best course of action to mitigate the additional cost? Extend the term of the loan or opt for a fixed rate? SD, Watford, Herts
Balance exercise: since December we have had six increases in the Bank of England’s key rate and it will continue to rise as long as high inflation persists
Jeff Prestridge responds: The first step is to review your mortgage contract urgently. Standard variable rate loans are rarely a good option, especially when interest rates are rising as quickly as they are now.
Since December, we have had six increases in the Bank of England’s key interest rate and it will continue to rise as long as high inflation persists.
A variable rate home loan offers no financial protection against rising interest rates. As sure as night follows day, any increase in the base rate is fully reflected in a variable rate loan.
Banks and building societies can be slow to raise savings rates, but when it comes to mortgages, they are easy to trigger.
By paying off a fixed rate loan, you lower your payments. More importantly, you’ll lock in one of your biggest financial expenses, giving you some fiscal security to offset the impending spike in energy bills.
I asked David Hollingworth, mortgage expert at brokerage L&C Mortgages, to do some math on your situation. He says you’ll likely be paying around £1,155 a month once the new mortgage rate of 5.99% kicks in next month.
But if you lock in a five-year fixed rate loan at 3.09% with First Direct, for example, you cut your payment to just under £974, a saving of over £181 a month, or £2,175 £ per year.
Of course, the savings would be even greater if the rate on your current loan increased to 6.49% in the coming months, thanks to another 0.5 percentage point hike in the base rate. Your monthly fixing saving would then be around £214.
This illustration assumes you have at least 35% of your home’s equity – most likely given that you’re almost halfway through your loan and it’s on a repayment basis where payments pay a combination interest and capital.
If you have less equity, fixed rate offers are more expensive, although you should still be in a better position than you are today.
As is typical in the industry, you will have to pay a fee (£490) to re-mortgage, but this cost will soon be wiped out by the savings from the repair.
There are other fixed rate agreements in more than five years. Two-year patches are commonplace, as are ones spanning ten years. For example, Virgin Money offers a ten-year solution at 3.3%, which isn’t much more expensive than the five-year First Direct deal. While ten years of payment certainty is appealing, Hollingworth says you need to make sure it aligns with your future financial plans. He says, “Many fixed rate loans have prepayment charges, so you need to be sure you’ll stay the course.”
For example, this fee on the ten-year agreement with Virgin Money starts at 8% of the outstanding balance, then decreases as the agreement is maintained.
When you take this first key step, you can also extend the term of your loan as you suggest. This would lower your monthly payments, although ultimately you would pay more interest in the long run. The chart, on the left, gives you an idea of the impact of extending your £125,000 loan on monthly payments and the total interest you end up paying.
Assuming a hypothetical repayment rate of 3.5% over the remaining 13 years of your mortgage, your loan would cost just over £998 per month – and you’d end up paying a total interest of £30,766.
Alternatively, extending the remaining term to 20 years would result in a lower monthly payment (just under £725), but you pay almost £49,000 in interest, which is £18,000 more than over 13 years.
Although the UK Finance banking association says 30-year mortgage terms are the norm, Hollingworth warns homeowners to exercise caution.
He explains: “When extending the term of a loan, a lender will need to ensure that the mortgage is affordable now and in the future. If the term extends beyond a person’s expected retirement age, they may need some assurance that the borrower’s retirement income will be sufficient.
So getting out of that expensive standard variable rate loan should be your priority. Extending the loan is of secondary importance.
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