Special Briefing: Fixed v Discount

MSE_Martin

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Special Briefing: Fixed V Discount

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Freddie_Snowbits

In the first place if there was a looking glass into the future in July 2002, I could have accurately predicted the way that the mortgage rate would have changed between then and now. I did not have this facility, so I had to make to some judgements based on the prevailing situation at the time.

I had moved in October 1999 to a new house after 3 years at university, 6 months of agreement! with my previous lender and, due to location, a new mortgage provider. After doing the legwork, I managed to get a 1.25% discount rate.

When I moved again in July 2002, interest rates had come down, they where just about at the bottom of the progress of their decline, I did some research and the Building Societies Fixed rates at the time were some 3.25% in excess of the discounted rate I was offered (now 1.75%), although they now included a absolute minimum rate for the duration of the discount period 5 years.

Historical data from the Bank of England, showed that had never been a succession of fifteen 0.25% increments since the institution was formed and a series of rate hikes had normally been followed, during the previous decade by an equal or greater number of falls. Using this I took out a discounted repayment mortgage in July 2002.

The main point of focus as I see it, is that the situation when you take out a Mortgage, can be very different in six months time. My second mortgage in 1989 was taken out in 1989, with payments fixed once a year when interest rates were 15.4%. The first review of payment was in 1991, the building society I was with would only review payments in April of the year, and not if you had been with them for less than six months. During that time the interest rates fell and subsequently I was well in advance by the time the review took place.

In the current situation, the margin of difference for an existing repayment mortgage payer between fixed and a discounted rate is marginal and it may be worth doing some leg work to see if a fix would be beneficial. On recent checking with my building society, I am now in a position, for a cost of £750 and a slight increase in payments, £14 a month, the possibility of a fixed rate for the rest of the term of the mortgage. The only problem is the long tie in, as one can see, I don’t think I can even stay in a house long enough to get cold feet.

Then again tomorrow we could wake to find out that the price of cod has gone :-X

Now where did I put that looking glass?

MarkyMarkD

A very interesting analysis, with some well observed points. But also a couple of dangerous (and oft repeated) conclusions.

The summary:

When looking for a mortgage, check out the difference between the fixed rate and the discount rate. The bigger the difference is the more you should hedge towards a discount rate. The smaller the difference the more you go towards a fixed rate.

rather lets the thing down, and reinforces a common misconception which is also alluded to elsewhere in the article.

As is stated, fixed rates are based on the City's perception of long-term rates, which move only vaguely in line with base rates (and can move in opposite directions, or the margin between fixed rates and base rates can move tremendously).

So to say that fixed rates are preferable when they appear LESS expensive compared to current discounted rates, and less preferable when they appear MORE expensive compared to current discounted rates, is far too simplistic and misleading.

Ceteris paribus (to quote Martin), discounted rates and fixed rates should be equally good value - they are both available in a competitive market and they are both equally likely to be good (or bad) value. The decision as to fixed/discounted should not really matter - on average, you will be just as well off with both.

Let me give an example because my meanderings to this point probably are not clear.

In the last 2 months, base rates haven't changed at 4.75%. But 5 year swap rates (the rates from which fixed rate mortgages are priced) have fallen by around 0.35% (from around 5.35% then to 5.00% now).

So, if lenders were offering a 5 year discount then for 4.99%, they'd make 0.24% per annum. If they offered a 5 year fixed then for 5.59%, they'd make 0.24% per annum. Both products represent equally good value - even though the fixed is 0.60% higher. The 0.60% represents the average amount by which the City expected rates to rise over that 5 year term.

Now that rates have moved, if the lender was offering the same rates, their profit margin on a 5 year discount wouldn't have changed at 0.24%. But their margin on a 5 year fixed would have risen to 0.59%, as they can now fund the fixed rate mortgage at a far lower rate because the City's perception of average rates over the next 5 years has fallen dramatically.

The fixed rate product would now represent far worse value, even though it's the same rate. The customer is not getting the benefit of the fall in swap rates.

So, to look at the gap between fixed and discounted rates and say "hmm, that isn't too big, so the fix looks like OK value" is simplistic.

Of course, what happens as swap rates move is that lenders will price their fixed rate products downwards as they can afford to do so. But right now, as rates have just fallen, many lenders will still be offering the higher rates which according to Martin's principle will still appear OK value to the uninitiated.

A nice site which shows 5 year swap rates (and a graph of their movements) is http://www.cavendish.propertymall.com/markets.php.

I should emphasise that the markets can get it wrong - and almost always will - but their view is the best one we've got to go on IMHO. The fact that 5 year swap rates are currently only 0.25% above bank base rates means that the market thinks rates won't rise much at all, and if they do rise they will fall again to produce something like a 5% average over the next 5 years. And on those rates, you won't have to pay much of a premium for the certainty of a fixed rate.

MSE_Martin

An interesting point Markymark. It made me go back and look at the article - which i must admit was writtne in an hour on the back of my friend asking me 'fix or discount'.

The summary was meant to be on top of the 'surety' arguement. However i realise that the way i'd done it made it look a standalone. So i have deleted it

I partially agree with what was said, but my key point is it is the 'surety differential'. While good value should be equal - the markets and always right and the choice is one of fitting to your pockets.

In fact if you look back at long term swop rates compared to the actuality - the markets are often substantially wrong.

Very interesting read though thank you - and thanks for the point about the summary - it was a nice constructive critique and think you've helped me improve the article

martin

Rootsie_2

Thanks for the article I was fairly confident I understood the subject matter before reading it and am more confident of this now.

However, what I do get seriously confused about is APR's. I am looking to remortgage and know what sort of mortgage I want, a base tracker repayment on which I can overpay with interest calculated daily. There are lots of these and all have different APR's. Obviously I want the best deal and there seems to be some association between charges and the APR. How does this work or am I imagining things.

More importantly, have you got any recommendationns?

Finishrich

The APR takes into account the full term of the mortgage eg 25 years, any arrangment fees, plus in your case the tracker rate say for the first 5 years or however long the original offer is for, then they use the standard variable rate to calucate the remaining 20 years of the mortgage and from all that produce the APR.

Have a look at https://www.charcolonline.co.uk there's a good example on the home page it shows 2 mortgages:

Rate of 3.99% with APR of 6%
and Rate of 4.24% with APR of 5.7%
So although the first one will be cheaper to start with over the full term of the mortgage it will be more expensive than the second one. Assumming you stayed with them for the full term, rather than remortgage after 5 years.

MarkyMarkD

The APR is a complete waste of time, as it shows you the effective rate over 25 years. No MSE has the same mortgage for 25 years.

On the https://www.charcolonline.co.uk site referred to above, when you are comparing you can specify how long you expect to have the mortgage for. It will then rank products in terms of their actual cost to you over that period - which is what you need to know, not the actual payable rate or what it would cost if you were daft enough to pay SVR for 20 or 23 out of 25 years.

So, ignore APR (and best buy tables for that matter) and use a meaningful comparison engine like charcol's.

SBM_2

Hi There,


The articles above are most interesting, and i follow the majority of the comments made.

I believe that although mortgages can be rather complex, and the majority of first time buyers have difficulty at first, that over the years often by trial and error you tend to find a better mortgage and begin as you get older to start to understand and indeed take more interest in financial matters. Working on that premise for a moment. the first time buyer in todays climate is going to go for the mortgage that they can most afford and indeed looks good at the time. e.g i bought my first house in 1988 and had an endowment mortgage. ( see what i mean ) just before the rate went up to nearly 15%. and not what probally in the long run would best suit them.
So getting to the point, i believe without making it to complicated, when the majority of people ask the question "what is best fixed rate or discounted", they understand that discounted is going to be less per month/ year than fixed over the short term, and are more trying to determine the future interest rates. They are asking do you think over 3, 5, 10, 15, years that rates are going to go up by large amounts.


Now every day in the press, on the radio and Tv there are experts giving us their opinions, and these people are basing their opions on a lot stronger financial understanding than i will ever have.

But can i be simple for a moment ( no jokes please )

Over the last sixteen yrs ( the time in which i have had a mortgage) the rates have fluctuated as you would expect. If you average these years out the rate at the moment is relatively low.

So would you not be better taking out a long fixed rate mortgage of 15 yrs say.

Are not the average rates over such a period more likely to go up than down. They can only go down by 3-5% depending on which mortgage you have, there is no ceiling on how high they can go.

Making the above comment, i have not considered can i afford for the rate to go up, or how much risk do i what to take, as mentioned in Martin's report. Just purley on, what is going to save me the most money over the long term.

Am i barking completly up the wrong tree?


Shaun

MarkyMarkD

Shaun

You have made a very profound point, which is that if you buy a fixed rate of (say) 5.5% for 15 years, your maximum downside risk is 5.5% x 15, as rates are unlikely to fall negative, whilst your maximum upside risk is without limit, as it is quite possible that there could be a hyper-inflationary disaster in the economy leading rates through the ceiling.

So, if you are concerned about certainty, and more about what could happen in extremis, then any best buy fix is better value than the best buy discount over the same period.

But, equally, taking a view based on probabilities, it should make no difference if you go for discounted or fixed. And due to the lack of competitive market for long term fixes (because only a very few lenders offer them) I would tend to think that they would represent worse value than best buy 2 year discounted products which are in a fiercely contested market segment.

My comments are all supposition and guesswork based on a fair knowledge of the mortgage market.

Every borrower should assess their own attitude to risk - if you hate risk, buy a fix (or better, a cap, but there are hardly any on offer right now) every time because you have the lowest downside risk. But if you have a balanced attitude to risk, you will probably save money on repetitive remortgaging between short-term discounts, rather than buying a 15 or 25 year fix and sticking with the same lender, IMHO.

allante

Hi
A question from an unlearned user.
If I take a fixed rate mortgage at say, 5% and the bank rate dropped to 2%, (unlikely i know!) would it mean that i was paying any extra off my capital or would the extra i was paying be purely interest going in to the coffers of the lender?
Also, if it was th eother way round and the bank rate went to 10%, when i had finished my fixed rate period, would the lender recoup the interest that i hadnt been paying or would it be their loss?

TIA

Andy

Robert_Sterling_3

You will sign a contract to pay the fixed rate for a fixed period of time. Then at the end of thet period you are free to negotiate new terms.