to the uninitiated, the range of mortgage products currently available is likely to be bewildering. But once you cut through the jumble of marketing buzzwords and jargon, the choice comes down to two basic types – fixed and variable rate products.
These can be further segmented into standard variable rate (SVR), fixed, capped, discounted and tracker mortgages. Each accounts for a share of the market, but the individual size of that share is determined by a number of factors that start with product proliferation.
Mortgage proliferation has been driven principally by competitive pressures, changing demographics and the growing ability of lenders to manage and control risk. However, the appeal and success of a particular product depends on a number of specific influences. These include the prevailing economic conditions, the product’s design features and price, the way in which it is marketed and the timing of this.
When all four come together, a product is likely to sell. This unremarkable fact helps explain the current dominance of short-term fixed rate mortgages over the other types.
To put this into context, the Council of Mortgage Lenders (CML) has recently reported that the majority of new borrowers are taking out fixed rate loans. It cites the desire for payment certainty at affordable cost as the principal reason. It is also likely to reflect keen market pricing and the view of borrowers that interest rates will remain stable in the short to medium term. This sentiment works against the inherent appeal of discount and tracker mortgages, which are usually perceived as offering best value when rates are falling, or thought likely to do so.
The CML’s own data from its recently introduced Regulated Mortgage Survey supports this scenario. This shows that across the four quarters of 2005, fixed rate products accounted for an average of 60.5 per cent of new lending. By comparison, discount and tracker mortgages accounted for an average of 13.5 per cent and just over 16 per cent respectively. This is brought even more sharply into focus when figures for the final quarter of 2005 are examined. These reveal that fixed rate deals accounted for a massive 76 per cent of new mortgages, with discounts and trackers falling to just 8 per cent and 12 per cent respectively.
Interestingly, looking back a full decade to 1996 reveals an altogether different picture. Then, fixed rate mortgages represented just over 19 per cent of all lending with discount products accounting for no less than 45.5 per cent of total new mortgages made. However, standard variable rate (SVR) products were also highly popular accounting for an average across the year’s four quarters of no less than 35 per cent of new lending (compared to a paltry 3 per cent in the final quarter of 2005).
The finer details
What is clear from this data is the continuing popularity of fixed rate mortgages. What then are the prospects for discount and tracker products?
A good starting point is to define what is meant by a ‘discount’ and ‘tracker’ mortgage (with acknowledgements to the Council of Mortgage Lenders and www.mortgages.co.uk)
A discount mortgage is sold with a discount period of a given term, usually two to five years. This period occurs at the beginning of a mortgage when the borrower qualifies for a reduced rate of interest and, therefore, reduced repayments. The discount is usually given off the lender’s SVR but can also be given off a tracker rate. If this rate falls, the repayments fall. Conversely, if the interest rate rises, so does the repayment.
Borrowers opting for a discount product should be advised to budget for a rise in repayments when the discount period expires. However, it is possible to find products that are marketed as being ‘discounted for life’, although the discount is likely to be off the lender’s more expensive SVR rather than against an external rate.
A tracker mortgage offered through a mainstream lender is usually linked to the Bank of England Base Rate (BBR), and requires the borrower to pay a set margin above the current level. Unlike most other types of promotional rate, many trackers will not revert to the lender’s SVR during the loan term. They will continue to track BBR until the mortgage is redeemed or switched to another provider or product. These are known as ‘lifetime trackers’.
Tracker mortgages that include discounts for a specific period are also available. However, early settlement charges will usually apply for full balance redemptions made during this period.
Tracker mortgages offered by some specialist, or non-conforming, lenders are more likely to be linked to LIBOR – the London Inter Bank Offered Rate – because of the way these lenders fund their activities.
The principal difference between LIBOR and BBR is that the former is a predictive measure based on the movement of rates over a given quarterly period. As such, LIBOR trackers tend to be more expensive than BBR linked trackers when rates are rising, but better value when they are falling. While LIBOR trackers therefore have their advantages, it must be conceded that as a measure of rate LIBOR is not generally well understood outside banking and mortgage circles.
That said, the considerable majority of trackers are linked to BBR and offer the great advantage of transparency. Borrowers appear particularly to like the fact that the full benefit of any reduction in rates will be passed onto them. This is not usually the case with many SVR-linked products. A further benefit is that any reduction must be passed onto the borrower within a specified timeframe as set out in the conditions of the mortgage. On the flip side, the borrower bears the brunt of any rise in BBR just as quickly.
Financial literacy
Given this transparency and the past popularity of both discount and tracker mortgages, it comes as a surprise to learn they still have the capacity to confuse consumers. This is illustrated by a couple of recent surveys that measured consumer understanding of trackers.
The first was carried out in late 2005 by Mortgages Direct, a broker, and revealed that one in four respondents thought a tracker mortgage tracked salary increases. The second and more recent survey was through Alliance & Leicester. It showed that well over half of respondents did not understand how a tracker works. Of these, 17 per cent thought the rate was linked to the performance of the FTSE 100, while 4 per cent believed it was a fixed rate. Only 34 per cent of those surveyed understood that the rate was linked to fluctuations in BBR. Some commentators have challenged the validity of these findings, but they nevertheless provide ammunition to those concerned about general standards of financial literacy.
While both discount and tracker mortgages have clearly lost ground to fixed rate products in recent months, they still have some attractive flexible features to offer, such as payment holidays and the facility to make overpayments without penalty. In addition, some tracker products are marketed with a ‘cap’. This allows the discounted rate to track down but only up to the limit of the cap.
However, many fixed rate products incorporate these same features. In addition, the respective advantages of discount and tracker products have become less distinct. This can be attributed to the present low level of interest rates, which has created an environment in which SVR-discounted mortgages are close in price to BBR-loaded trackers.
But there are still aspects that can make a difference to the overall appeal of either product, and borrowers are well-advised to look at these closely when considering their options. Arrangement and exit fees in particular can make a real difference to the overall cost of a mortgage. As can extended tie-ins or overhangs – particularly on discount mortgages. However, these are often not featured in fixed rate products, which only serves to increase their appeal.
Fixed favourite
Looking at the full picture, it is unlikely in the short-term that either discounts or trackers will replace two and three-year fixed rate mortgages as the consumer’s favourite option. Some commentators hold to the view that the popularity of these products has peaked and that they now offer less attractive savings. They point also to uncertainty about the future direction of interest rates and upward pressure on money market rates. Nevertheless, fixed rate pricing remains attractively low across the board. And borrowers continue to show an increasing appetite for having control over their finances. Small wonder then that the CML’s market commentary for March 2006 confirms that fixed rate borrowing accounted for no less than 75 per cent of all new mortgages with discounts and trackers coming a poor second and third.
Adam Henry is sales and marketing director at Money Partners plc
