Choosing the most suitable interest rate structure

The first question that most people ask when considering a new mortgage is 'What type of interest rate structure is best for me? - Should I take a fixed rate, a capped rate, a discounted rate, a stepped rate, a standard variable rate or a cashback deal?' Indeed this all important question is one that needs very careful consideration. So let's look at each of these options in turn and attempt to simplify the choices available.
Fixed RatesFixed rate mortgages are available on a variety of terms and for most periods. At one end of the scale there are some very short term deals fixed for say 6 months, and at the other end of the scale there are offers that will fix the rate for the entire term of the mortgage. So should you opt for a fixed rate and if so what are the catches to watch out for? The decision you make here will normally depend on two factors. The first is what you feel will happen to interest rates over the coming months/years and secondly your approach to risk. Let me explain in more detail - If you feel that interest rates are likely to fall then it is unlikely that you will want to tie yourself in to a fixed rate for any period, particularly if you feel that the normal variable rate is likely to fall below the fixed rate. You will probably feel more inclined to take a discounted rate in these circumstances as you can then benefit from any fall in interest rates with a reduction in your mortgage repayments. The second consideration that will influence your decision is your attitude to risk. If you like to budget with certainty then you will probably want to fix your repayments for a reasonable length of time. Equally important is the amount of leeway you have with your budget and whether you can afford to meet any increase in repayments. If you are a first time buyer and have borrowed to your maximum limit then it is probably sensible to fix your repayments at a level which you can comfortably afford. If there is little 'slack' in your budget then you must consider 'can I really afford to take a chance on interest rates rising?' So, if you decide to opt for a fixed rate what are the catches and what points should you particularly watch out for? First let's look at the disadvantages of taking a fixed rate. Clearly the most obvious disadvantage is if interest rates fall - in this case you could find yourself paying more than you would have had to with a variable or discounted rate. If you have opted for a long term fixed rate then this decision could cost you dearly over the period of the fixed rate. You will also find that, with most fixed rates, you will be charged a penalty (called a redemption penalty) if you wish to change your mortgage or pay it off completely or in part in the first few years. With most fixed rate mortgages this penalty will certainly last for the term of the fixed rate and it is quite common for these penalties to extend beyond the fixed rate term, thereby tying you into that mortgage for a number of years after the fixed rate has finished. These redemption penalties are usually imposed at a level that would make it uneconomic to change the mortgage or transfer to another lender whilst the penalty is in place. There many lenders who offer fixed rates without redemption penalties or with penalties that only last during the fixed rate period. These products are certainly worth considering although you will usually find that, as a result of this, the rate offered is not the most competitive in the market. However, you do then have additional alternatives if interest rates work against you and you could be free to negotiate an alternative rate with the lender or, if the worst comes to the worst, move to a different lender.
Capped RatesA capped rate will give you the best of both worlds between a fixed rate and a variable rate. The cap is basically a ceiling on the interest rate above which it will not rise. On the other hand, if the normal variable rate falls below the capped rate then the variable rate will be charged. So, you have a guaranteed maximum rate with the benefit of a reduction in interest rate if this happens - sounds too good to be true? Well there are some catches - first you will usually find that the cap is set at a higher rate than the best fixed rates for a similar period. So, for example, if a capped rate is offered for 5 years capped at 8% you may find the best five year fixed rate is being offered at 7%. Secondly, you also need to watch out for redemption penalties as with fixed rates. The third point to watch out for is that sometimes these products are sold as 'cap and collar' products. This basically means that, as well as a ceiling on the interest rate above which it cannot rise there is also a collar on the rate which is a level below which the rate cannot fall. For example a product may be sold with a cap of 8% and a collar of 5% for 5 years. This means that within that 5 year period the interest rate is guaranteed not to rise above 8% but it will also not fall below 5% within that time either. This means that if the normal variable rate falls below the collared rate you will be paying 'over the odds'.