With interest rates falling to a two-year low and the much publicised price war between lenders helping to push product innovation onwards, the prospects for first time buyers are, in theory, good.
However, while there are now some very attractive headline rates, first time buyers should be advised to look beyond the initial rate and work out whether they can afford to meet repayments after the initial discount, and whether there are any redemption penalties to tie them into this higher rate.
Redemption penalties are the fees charged by lenders to discourage people from repaying the loan early or from switching to another lender during the initial discounted period. Redemption penalties can be built into any mortgage, but they are most common on discounted and fixed rate loans ‘ which are the typical loans taken out by those buying for the first time. Although there are now fewer lenders who impose redemption fees beyond the special rate period, they remain fairly common on those mortgages with a deeply discounted initial rate. Indeed, they can often include an overhang period of up to five years where the borrower is expected to pay the lender’s standard variable rate. People wishing to remortgage in this period and take advantage of lower rates elsewhere will face varying redemption penalties. Some loans will use a sliding scale where the penalties reduce over time, but others will charge an exact amount regardless of how far into the term the borrower is. Either way it can be very expensive for first time buyers to remortgage during this period.
Eddie Smith, director of business development at Verso, says: ‘Faced with a number of rates, first time buyers are often pulled towards the lower initial rates. Our feedback shows that most first time buyers will look at the initial rate and take their chances afterwards.’
This may cause serious problems for first time buyers, because in some cases, repayment levels can almost double after the initial period. Mark Smitheringale, head of corporate communications at Skipton Building Society, says: ‘A downside to overhanging redemption periods is that the initial rate is usually substantially lower than normal. After this period, there can be a big payment shock as repayments can sometimes become twice as much as the initial rate. Often people find their mortgage repayments double overnight and it can be a shock both to their budget and their lifestyle.’
A short, sharp shock
Rob Clifford, managing director of mortgageforce, agrees. ‘The rate payable today remains of paramount importance to first time buyers, which is precisely why first time buyers can sometimes select the wrong products. The desire to depress costs at the outset can be a problem later when they are faced with a whole lot of new costs after the initial period,’ says Clifford.
Despite this, first time buyers should not necessarily be advised to avoid deeply discounted mortgages that have redemption overhangs at all costs. As with all mortgages there are advantages and disadvantages and whether the product is suitable for the first time buyer will depend very much on their personal situation.
Smitheringale says: ‘It is something very much down to the individuals’ personal circumstances and choice. A lower rate with an overhanging redemption period can substantially reduce the up front costs in the early years, which can be useful because it is an expensive process. First time buyers can often be very keen to keep their repayments down while they spend their money on other things such as white goods.’
In addition, an overhanging redemption period may not necessarily be a problem if the client does not plan to move house again for a number of years, and they think that they will still be able to afford the higher repayments after the first few years. Tim Sturley, head of business development at Mortgage Express, says: ‘First time buyers by definition do not tend to have a lot of spare money. So, if they choose a discounted mortgage with a redemption overhang and they plan to live there for a number of years they can divert cash initially into buying fixtures and fittings to make their house more of a home, before the end of the discount.’
Top of the agenda
Smitheringale believes that redemption penalties should be a topic that is high on the agenda for discussion with first time buyers. ‘Some first time buyers are looking to buy and live in the property for a long time, whereas others just want it for a short time as they try to work their way up the housing ladder. They may be in an occupation where they need to buy a property, but in two or three years’ time they may be earning more money and can move again. An overhang period would therefore put them at a disadvantage when they were looking to move in two or three years’ time,’ says Smitheringale.
The so-called price war has also meant very low discounted rates are now much less prevalent in the market than they were a few years ago, and there are now more mortgages with higher initial rates that are closer to the lenders’ SVRs.
However, Ray Boulger, senior technical manager at Charcol, says: ‘Low headline rates will continue to be offered because some people want them, and if there is a demand then it is only right that they should be offered.
‘But people should understand both the downsides and the upsides. They may only end up looking at the initial payments which is a worry and this could be mitigated by the use of illustrations that show repayments. If people are sold products without enough emphasis on the negative side it can be a problem.
‘If you look at a rate without redemption penalties, you can usually find a mortgage at a slightly higher rate initially, and then remortgage for a lower rate after two to three years. After this time most first time buyers will find that their circumstances have changed.’
Mortgages that include overhanging redemption periods have been criticised recently by a number of regulatory and consumer groups for a lack of clarity, which has led to people taking out unsuitable loans.
However, lenders now appear to be heeding this, which should help to make these mortgages more transparent, helping first time buyers to decide which is the most suitable product for them.
Smitheringale says: ‘There is a trend among lenders to move away from deep discounts and long overhang periods due to consumer and regulatory pressures. The industry is in an unsustainable situation where long-term customers are subsidising short-term customers. People should not forget that, if they have had a particularly low rate, lenders are not charities and have to get the money back somehow. There is a move towards rewarding long-term customers with higher rates initially and no overhanging redemption penalties.’
Keeping a balance
When first time borrowers are offered special deals, they are in effect being subsidised by the existing borrowers. But lenders have found it costs more to attract new customers than it does to keep existing ones, and they can no longer afford to keep doing this with the increased competition.
Clifford says: ‘Consumers have to realise there is no such thing as a free lunch. These discounted products are loss leaders for lenders and it is rare for them not to want to try to claim some of it back later, but these products should be able to continue as long as there is full disclosure and transparency from the lender.’
So, while there are some advantages to taking out a mortgage with an extended redemption period it is clear that first time buyers may be storing up problems for the future. First time buyers are usually interested in climbing onto the property ladder with as little initial outlay as possible, but depending on their circumstances, they may be better advised to look at paying a higher initial rate with no redemption overhangs. If the first time buyer can afford this higher repayment rate for the first few years they may find it easier to meet payments as time goes on and their salary increases, and they will also find it easier to remortgage onto a lower rate sooner.
There is no clear cut choice as to which is better for the first-time buyer a loan with a cheaper initial rate and a redemption overhang or one with a higher rate and no overhang. The most important factor is that the borrower fully understands the mortgage and it suits their needs, which is something that can only come from advice.
Low rate, with extended redemption charges.
Client A ‘ Assumed income of £20,000.
House purchase price £70,000, client A puts down a 5% deposit and therefore needs a mortgage of £66,500. The client takes out a repayment mortgage with a low initial rate, as he has only just started work and needs to minimise costs. However, he is confident of future pay rises and does not mind being tied into a higher rate when the discount finishes.
The mortgage rate is 4.74% (variable) equal to a 0.51% discount off Bank of England base rate until 30/6/2003, with three-year extended tie in and then reverts to Bank of England base rate plus 1.0.%. Redemption charges are 5% until 30/6/2003 then 4% until 30/6/2005 then 3% until 30/6/2006. After 36 monthly payments at £383.02 per month client A will have paid £13, 7888.72.
l If Client A redeems his mortgage in the first two years of the tie in period he will have pay £2,660, and £1,995 in the final year, plus any administration fees.
Slightly higher initial rate but with no extended redemption charges.
Client B ‘ Same income, house price and mortgage size as with Client A.
Client B has taken out a mortgage with no extended redemption charges because he wants the freedom to move or change mortgages in a couple of years if necessary. The mortgage interest rate is 5.40% (variable) equal to Bank of England base rate plus 0.15% until 30/6/2003. The rate then reverts to Bank of England base rate plus 1.0% Redemption charge is 5% until 30/6/2003. No extended redemption charges. After 36 monthly payments at £409.11 per month, client B will have paid £14, 727.96
l However, if client B redeems his mortgage after the discount period he will only be liable for any administration fees.