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Discount mortgages

The interest rate on a discount mortgage is set below a lender's standard variable rate, but watch out for the risks involved.

In this article
What is a discount mortgage? How does a discount mortgage work? How much can I save? What happens when your discount term ends?
Pros of discount mortgages Cons of discount mortgages Is now a good time? Is a discount mortgage right for me?

What is a discount mortgage?

With a discount mortgage, the interest rate you pay is a discount on your 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 at the beginning of April 2018 was 4.99%, according to Moneyfacts.

A discount mortgage is a type of variable-rate mortgage, meaning the amount you pay each month could change.

 

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Your home may be repossessed if you do not keep up your mortgage repayments.

How does a discount mortgage 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%.

Lenders have different SVRs, so a larger discount doesn’t always mean you have the lowest interest rate.

How much can I save?

With a discount deal, your interest rate will generally stay a set percentage below the lender’s SVR. This means you can benefit from low-rate swings, while staying below the amount you’d pay on an SVR mortgage.

That said, often the discounted interest rate cannot fall below a certain percentage - which is known as the ‘collar’. At the beginning of June 2018, around a quarter of all discount mortgages had a collar.

Some collars are the same as the initial discounted rate when you took out the deal.

For example, if the lender’s SVR is 5% and they offer a mortgage with a 4% discount, this means your initial interest rate is 1%. Even if the SVR later drops to 3%, your rate will not go lower than 1% during the deal.

Yet most discount deals have no upper limit - meaning if the SVR skyrockets, your payments could increase significantly.

What happens when your discount term ends?

Discount mortgage deals are usually offered for a limited timeframe.

The longer you receive a discounted interest rate on a mortgage deal, 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 - either another discount mortgage, or a fixed-rate or tracker deal.

Pros of discount mortgages

  • Your rate will generally 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’s base rate) your discount mortgage deal may have a very low interest rate.
  • Deals tend to be flexible, and often have no early repayment charges.

Cons of discount mortgages

  • 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 will face a large and sudden increase in their interest rate when they're moved to their lender's SVR.

Is now a good time?

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’s 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 will often pass this on to customers - though not always to the full 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 more hikes are expected in the coming year.

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.

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.

Discount mortgages are often flexible, which means they generally don’t have an Early Repayment Charge (ERC). An ERC is a charge that applies if you pay off your mortgage early or make an overpayment above a certain allowance. This kind of flexibility is one reason why you might prefer a discount mortgage.

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Correct as of date of publication.


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