What is a discount mortgage?
A discount mortgage is a home loan where the interest rate is pegged at a set amount below the lender’s standard variable rate (SVR) for either a set period (e.g. two or five years) or for your whole mortgage.
The SVR is an interest rate set by your lender, which it can raise or lower by any amount and at any time. The average SVR in December 2018 was 4.9%, according to comparison site Moneyfacts.
A discount mortgage is a type of variable-rate mortgage, meaning the amount you pay could change from month to month.
How do discount mortgages work?
When you repay your mortgage, part of the money goes towards the interest charged by your lender, and the other part towards repaying the money you've borrowed.
The saving you make on a discount mortgage only applies to the interest that you pay.
For example, if a lender has an SVR of 5% and the discount is 1%, the interest rate you will pay is 4%. And if your lender raised its SVR to 6%, your discounted interest rate would also rise – in this case to 5%.
If your interest rate rose, your monthly mortgage payments would rise but you would be paying more interest, rather than repaying more of the money you'd borrowed.
The largest discount you could get on a lender's SVR in December 2018 was 4.36%, while the smallest was 0.01% according to Moneyfacts. But lenders have different SVRs, so a larger discount doesn’t always mean you have the lowest interest rate.
- Find out more: use our mortgage interest calculator to work out how much your monthly mortgage repayments could change if interest rates rise.
How much can I save with a discount mortgage?
In times of generally low interest rates, discount mortgages have the potential of being seriously cheap.
However, they sometimes come with a 'collar', which is a set rate that they can't fall below. In December 2018 around a quarter of all discount mortgages had a collar, according to Moneyfacts.
Some collars are set at the rate you're paying when you take out the deal, which means that you won't benefit from any decrease in your lender's SVR.
For example, if the lender’s SVR is 5% and they offer a mortgage with a 3% discount, this means your initial interest rate is 2%. But if there was a collar of 2%, even if the SVR later dropped to 3%, your rate would not go lower than 2%.
Yet most discount deals have no upper limit - meaning if the SVR skyrockets, your payments could increase significantly.
What happens when your discounted period ends?
Discount mortgage deals are usually offered for a limited timeframe of between two and five years. The longer the discounted period, the smaller the amount of the discount tends to be.
When this timeframe comes to an end, your lender will usually transfer you onto its SVR automatically. This means that your monthly repayments will increase, as you’ll be paying a higher rate of interest.
At this point, you’ll usually be better off remortgaging to a new deal.
Pros and cons of discount mortgages
- Your rate will stay below your lender’s SVR for the duration of your deal.
- In certain economic circumstances (for example if SVRs are generally low due to the Bank of England base rate) you could be paying a very low interest rate.
- Your discounted interest rate tracks your lender’s SVR, which can change by any amount and at any time - meaning your monthly repayments might not be the same each month. If you're on a tight budget and need your repayments to stay the same, a fixed-rate mortgage may be more suitable.
- A discount mortgage may have a collar, so that your discounted interest rate cannot fall below a certain percentage, limiting how much you benefit from falls in the SVR.
- Borrowers with large discounts may be in a particularly vulnerable position when their deal comes to an end, as they could face a large and sudden increase in their interest rate when they're moved to the lender's SVR.
Is a discount mortgage right for me?
When deciding whether to choose a discount mortgage, it’s worth considering your attitude to risk.
If the initial interest rate on a discount mortgage is much lower than on a fixed-rate mortgage, and you think that interest rates will stay low for the next few years, you may decide to take that risk to potentially save money.
But if you need your interest payments to be predictable into the future, a discount deal will not offer you that security over the long term.
Is now a good time to get a discount mortgage?
Because discount deals are pegged to the lender’s SVR, you should weigh up the likelihood of the SVR increasing over coming years.
A lender’s SVR is influenced by a range of factors, one of which is the Bank of England base rate.
The base rate is set each month by the Monetary Policy Committee, with the aim of keeping inflation at about 2%. When the base rate rises, lenders tend to raise their rates, and when it falls, they may also pass this on to customers - though not always to the same extent.
Since the financial crisis, the UK has seen an era of low interest rates compared to previous decades. That said, in November 2017, the base rate climbed from a record low of 0.25% up to 0.5%, and it rose by another 0.25% in August 2018 to 0.75%.
Taking out a discount mortgage when rates are low can be attractive, but bear in mind that the base rate - and therefore lenders' SVRs - are expected to start creeping up over coming months.
- Find out more: mortgage types explained