The mortgage overpayment paradox

Here is a curious paradox to ponder on. Each year, millions of shoppers push and shove their way through endless crowds in the January sales, sifting impatiently through shelves of clothes and electrical goods, snarling at those whom they believe are trying to snatch 'bargains' from under their noses. And all to shave a few pounds off a shopping bill.

At the same time, according to mortgage experts, the vast majority of UK households remain oblivious to the fact that they are paying billions of pounds more than they need to each year on totally uncompetitive home loans.

According to research, up to two thirds of mortgage borrowers are on variable mortgage rates, the bog-standard product available from lenders, even though in most instances they could switch quite easily to far cheaper fixed or discounted home loans. On a typical £100,000 mortgage, their savings could run to thousands of pounds.

Why do we let it happen?

A variety of reasons have been advanced to explain this state of affairs:

1. "Our mortgage company must be competitive or it would not be able to remain in business."

Not so. In fact, lenders' hyper-profits are derived largely from the inertia of the majority of their borrowers, whom they overcharge compared to those seeking out the best deals.

2. "There's too much hassle involved in changing mortgage providers."

Not so. Switching your loan nowadays often involves little more than picking up a phone. Many lenders are so desperate for your business that they'll do all the hard graft for you.

3. "The initial costs and charges will outweigh any savings made by switching mortgages."

Not so. A 1 per cent drop in the cost of a £100,000 repayment loan cuts the mortgage bill by £60 a month – and there are lots of two and three-year deals that are far better than that.

4. "There's always a catch."

Not necessarily so. Some lenders try to act clever, offering cheaper loans in return for you taking out expensive insurance, or levy heavy penalties for early redemption. But there are plenty of other deals around that don't.

You should be a tart

Given these facts, it's not surprising that a small but increasing number of borrowers have decided that the most sensible thing they can do is to become 'rate tarts', a somewhat unkind term for those who switch their mortgages regularly.

In this instance, a rate tart is definitely the thing to be.

What's best: fixed or discounted?

A fixed rate is pegged at a certain level below the so-called standard variable rate, or SVR, for a set number of years. Discounts generally move up or down in line with the SVR, usually for no longer than three years.

Endless hours can be wasted trying to decide on the best choice between these two types of mortgages.

The important thing to realise is this:

Fixed-rate mortgages are priced on the basis of longer-term rates generally available on the money markets – lenders buy tranches of money – they then offer these to their borrowers. There is a cost to the lender for obtaining this wedge of cash.

Discounted mortgage rates, on the other hand, are decided on at a lender's head office. The rate is seen as a loss leader, priced to take into account the likely inertia of borrowers at the end of the discounted period.

Which type of mortgage is right for me?

How different are rates likely to be?

Both rates are dependent on estimates of where the market is likely to be in a few years' time.

Ray Boulger, a mortgage guru at Charcol, the mortgage broker, reckons that, historically, money markets generally tend to err on the conservative side, pricing in higher rates than subsequently come to pass.

The cumulative effect of that conservatism is not great over time, however.

Some research I did for the Financial Times last year showed that over most two-, three- and five-year time-frames going as far back as 1987, the best discounted rates generally tended to just shade the best fixed rates over the same period.

The savings were not substantial, however, running to a few hundred pounds - at most - on a typical £100,000 loan.

Under normal circumstances, then, taking out either type of loan need not be a matter of deep regret a few years on.

One important exception

There always is, isn't there? That exception is happening right now: anyone who took out a discounted mortgage at some point in the past three years is likely to have benefited to a far greater extent than those who went for the fixed option.

The reason is simple. The threat of economic recession over the past three years has forced the Bank of England to repeatedly cut its own base rate, in turn leading lenders to cut the cost of their own loans.

So what do you do next?

In theory, it's quite simple: if interest rates are likely to rise, go for a fixed-rate deal. Conversely, if base rates are falling, discounts are best because they are linked to a variable rate and should fall.

Today, it is possible to find a three-year fixed rate as low as 3.6 per cent, without extended penalties. Over five years, there are fixed deals on the market at 4.25 per cent.

On the discounted side, three-year deals are similarly-priced at 3.6 per cent, with five-year options sitting at 3.95 per cent or slightly lower.

What the experts think

The consensus is that Bank of England base rates, currently 3.75 per cent, may come down further in the next 12 months by another 0.25 percentage points, perhaps 0.5 points at most. Thereafter they will begin to drift back up again. No-one expects rates to rise above 5 per cent in the immediate future.

If so, those on discounted rates will gain in the short-term but lose out in the longer term. But the gains and losses should cancel each other out over five years.

What would I choose?

Most personal finance writers hate to stick their necks out, but I'll be an exception. My own view is that an economic recovery will be delayed for longer than the optimists believe and, therefore, that rates will remain low.

That points to a discounted mortgage, preferably over just two years, enough to catch a continuing base rate downside while avoiding too much of the upswing. Right now, you can pick up a two-year discount for 3.4 per cent if you look hard enough.

There is one important exception to note: fixed rates offer greater security. You know exactly how much you will be paying on that loan each month for years in advance. If that matters to you, ignore my earlier comments.

Either way, as has been indicated, it shouldn't matter too much which re-mortgage option you go for. Switching to one or the other will leave you quids in.

Maybe, just maybe, you might even be able to avoid having to barge into me in the next January sales...

Nic Cicutti writes for the Financial Times, Sunday Telegraph and Esquire magazine.

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