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Discounted or tracker mortgage - Ask our expert

Dear Chris, I’ve heard experts say that the base rate is going to stay low well into 2010 and perhaps even longer. I’d like to make the most of it by switching to a cheaper variable rate mortgage.

Is it better to get a tracker mortgage or a discounted mortgage? Is there much difference between them?

Kind regards,

Clive, via email Monday 28 September, 2009

On the subject of whether to get a discount or tracker mortgage, our expert says...

Hi Clive,

Thanks for getting in touch. Your question is one that many people may be grappling with at the moment as fixed-rate mortgages look expensive and borrowers are seeking to make the most of current low interest rates.

The percentage of people choosing discount and tracker mortgages has increased threefold over the summer months, according to mortgage brokers John Charcol.

Both tracker and discount mortgage rates are variable, which means they can increase or decrease during the term of you mortgage, so your repayments are not fixed. The crucial difference between them is what causes the rate to change, as follows:

Tracker mortgages are usually linked directly to the Bank of England base rate. This means that when the base rate rises or falls, your rate will increase or decrease by the same amount automatically.
Discount mortgages are usually linked to the lender’s standard variable rate (SVR). When the SVR is increased or decreased, your rate will increase or decrease by the same amount automatically. However, lenders have complete control over their SVR and it is completely at their discretion whether they pass on any increases or decreases in the base rate. They can change their SVR by any amount at any time.

Historically, tracker mortgages have seemed more attractive because with a tracker mortgage you are guaranteed to benefit from any cuts in the base rate, whereas a lender may choose not to reduce its SVR.

However, as the base rate is currently at a historically low level of 0.5% and most experts agree the only way for it to go is up, the relative benefits of each have changed.

If you take out a tracker mortgage now, you are guaranteed to feel the full force of future base rate increases, while with a discount mortgage there’s a chance your lender won’t pass on the full increases in the short-term.

As Ray Boulger, mortgage expert at brokers Jon Charcol (www.charcol.co.uk), recently pointed out: “With most SVRs now between 4% and 6%, and the most expensive at 6.45%, the spread above base rate is so large that it is more likely to narrow then widen from here.”

He believes this will happen either when funding for the mortgage market improves, thus increasing competition, or when the base rate rises significantly.

So, when the mortgage market improves lenders may choose not to pass on base rate rises to their SVR customers, in order to keep their rates competitive. Or, if the base rate rises dramatically, some lenders may not pass the full increase on.

Boulger advised: “Discount mortgages are now likely to perform at least as well as trackers, and in some cases better over the medium term.”

This makes discount mortgages appear more attractive, because rate rises are not guaranteed, but it’s important to remember that lenders can increase their SVRs at any point, regardless of whether the base rate has increased.

Historically lenders kept their SVR tightly coupled to the base rate at around 2% above it. While some have retained that relationship during the last year of low base rates others have much higher SVRs than the current base rate – as much as 6% more.

Do your homework and examine your lender’s recent SVR history alongside movements in the base rate, to help you decide if you want to take out a discount mortgage with them.

Furthermore, you need to bear in mind that the base rate is not guaranteed to stay low into 2010. So whether you choose a discount or tracker mortgage, you need to have assessed how your finances would cope if the base rate did jump suddenly and you monthly repayments increased.

I recommend you contact an independent financial adviser or whole-of-market mortgage broker, who will be able to discuss your options with you and offer advice tailored to your circumstances.