First-time buyers: how to find the best mortgage rate with a 5% deposit

Buyers with a 5% deposit can get a lower mortgage rate by taking out a discount mortgage, but are variable-rate deals worth the risk?

The cheapest introductory rate on a 95% discount mortgage is significantly lower than that of an equivalent fixed-rate deal, even when factoring in a possible rise in the Bank of England base rate, according to new research by Which?.

Here, we explain how discount mortgages work and offer advice on the key things first-time buyers should weigh up when choosing a mortgage.

Discount mortgage leads the way for buyers with small deposits

Discount mortgages aren't nearly as popular as fixed-rate products, but first-time buyers might just be able to grab a bargain by going down the discount route.

Loughborough Building Society is offering a market-leading 95% two-year discount mortgage with an initial rate of just 1.99%.

That's 0.5% cheaper than its nearest competitor in the discount market (Teacher's, at 2.49%), and 0.6% cheaper than the lowest-rate two-year fix (2.59%).

This price gap means that even if Loughborough hiked its standard variable rate(SVR), the deal would still be likely to remain cheaper than its competitors.

Loughborough discount mortgage: the details

• Rate: 1.99%: a 3.35% discount on the lender's SVR (5.34%) for two years.
• Maximum loan: £350,000
• Fees: £999
• APRC: 4.7%
• Availability: England and Wales
  

  ---

How discount mortgages work

Discount mortgages are variable-rate deals that usually come with short introductory terms of two or three years.

During this period, you'll be charged the lender's SVR, minus a set amount. So if the SVR is 5% and the discount is 3%, your initial rate will be 2%.

Discount deals can be risky, as the margin (3% in this example) - rather than the rate itself - is fixed for the period. So, if your lender increases its SVR to 5.5%, which it could choose to do at any time, you'll need to pay a rate of 2.5%.

It's often the case that the headline rates on discount deals are slightly cheaper than fixed-rate products, but just a small rise in the SVR can quickly make them more expensive.

• Find out more:learn about the pros and cons in our gull guide on discount mortgages.

SVRs and the base rate

You might be surprised to learn that lenders'SVRs vary dramatically - and this will have a big effect on how much you'll pay if you're taking out a discount mortgage.

Currently, Atom Bank has the cheapest SVR (4%) and Marsden Building Society the most expensive (6.2%).

Right now, the average SVR across the whole market is 4.89% - that's the second-highest level seen in the past decade.

While SVRs can change for a number of reasons (business needs, the cost of borrowing for banks etc), the single biggest thing that affects them is changes to theBank of England base rate(currently set at 0.75%).

When the base rate increases (as it did in November 2017 and August 2018), lenders usually pass the burden on to borrowers.

You can see the effect of base rate rises and falls on SVRs in the chart below.

Are discount mortgages cheaper than fixes?

As the chart below shows, at every loan-to-value ratio (LTV) other than 95%, discount mortgages are only very slightly cheaper than their fixed-rate equivalents.

The biggest gap is at 60% LTV, where discount deals are 0.17% cheaper. At 90% LTV, the gap is only 0.04%.

With the possibility of SVRs changing at any time, the question of whether it's worth taking a punt on these deals depends on your appetite for risk and what you think might happen to interest rates in these turbulent times.

What happens if the base rate rises?

In truth, nobody knows what's going to happen to the economy, as uncertainty continues around Brexit.

The Bank of England governor Mark Carney has suggested a rise in the base rate could happen this year, so it's worth considering how a 0.25% hike could affect the cost of a discount mortgage, assuming your lender added the full increase to its SVR.

As the chart below shows, with the exception of 95% mortgages, the best discount rates at each LTV would become more expensive than the cheapest fixed-rate deals.

The new Loughborough discount deal discussed earlier, however, would be cheaper than the current lowest-rate fix even if there were twobase raterises of 0.25%.

You can find out how an interest rate rise would affect your monthly mortgage payments using our mortgage interest rate calculator.

At a glance: pros and cons of discount mortgages

Longer-term mortgage deals

We've only analysed two-year discount and fixed-rate mortgages here, but what about longer-term deals?

Over the last year, the gap in cost between two- and five-year fixed-rate deals has closed significantly, as an increasing number of homebuyers and remortgagers have chosen the security of a longer-term fix.

If you're looking to secure your rate for five or more years, you're unlikely to find many options in the discount market.

A small group of lenders - Bath, Beverley, Buckinghamshire, Loughborough, Mansfield, Melton Mowbray, Newbury, Scottish Building Society, Tipton and Coseley and Vernon - offer three-year discount deals at 95% LTV, though some of these deals are only available to people in specific professions, or require financial assistance from a family member.

In the five-year market, meanwhile, only three lenders - Earl Shilton, Hanley Economic and Loughborough - offer discount mortgages.

With this in mind, borrowers in search of longer-term rate security would get a lot more choice by opting fora fixed-rate deal.