UK Discount-rate mortgages explained; A complete guide
Discount-rate mortgages; A simple definition
If you haven’t already done so, it would be worth reading our guides to variable-rate mortgages before looking at discounts.
Discount-rates are essentially just a variable rate with a discount for a set period.
For example, if a lender's variable-rate was 4%, they might offer a 2-year discount of 1% giving you a payment-rate of 3%.
Once the 2-year period came to an end you would “revert” back to the lenders variable-rate.
So in this example, if there had been no changes to rates made by the lender during the 2-year deal your payment rate would then increase back to 4%.
As with variable rates the lender can change the underlying rate at any time, altering your payments up or down.
Although these changes are generally likely to follow the Bank of England Base Rate, they don’t have to.
You will tend to find discount-rates being the cheapest available in the marketplace, but they are typically riskier than trackers due to the lender controlling the rate, and much riskier than fixed products where the rate cannot change initially.
Discount products tend to come with early repayment penalties though and these would generally end once the discount period finished.
As with all products that change back to a higher rate at the end of the deal you can arrange to switch to a new deal just before the end of the discount, either with the current lender or by remortgaging to a new one.
UK Discount-rate graph
Discount mortgage deals; How they work
In the chart above we see the behaviour of discount-rates compared to the Bank of England Base Rate (BOE Rate) and the lender's variable-rate.
In this example, the customer has a discount of 0.5% until October in that year. In January the lender's variable-rate is 2% so the customer is paying a rate of 1.5%.
You can see that the lender's variable tends to follow the BOE rate changing by a similar amount, usually within a month or so of the change in BOE rate.
This, in turn, alters the customers discount rate too and their payments up and down with it.
It’s important to note that the lender doesn’t have to change in line with the BOE rate, so in this example, the lender chooses not to pass on the reduction in BOE rate in August/September.
You should remember that the lender sets the rate and hence they could change it at any time for their own needs usually by any amount.
In October the customers discount period ends and they “revert” back to the lender's main variable-rate.
The customer could have arranged a new deal either with their existing lender or by remortgaging to a new lender in the months before the discount ended ready to switch over as soon as the deal finished
Discount-rate mortgages; Who should take these deals?
Discount rates tend to be the cheapest available deals and are typically available for 2, 3 or 5 years although sometimes other lengths may be available.
This means that in the earlier years of a mortgage where the long term impact on cost from relatively small differences in rates has the highest effect they can present good value for money.
But they are also the highest risk products of most normal mortgages available from high street lenders.
They tend to have early repayment penalties during the discount period and no upper limit on what the rate could be.
This means the rate could rise steeply without warning and you would need to pay a sizeable penalty to escape the deal and change to something else like a fixed-rate.
For this reason, customers need to be extremely careful not to just select these products purely because they are cheap and careful consideration should be given to the economic climate, the likelihood of rate increases, and whether they can afford potential increases in costs.
So customers who can afford potential fluctuations and are comfortable with the risk of increases but want the best value for money may often find discounts the best option.
As most discount rates are offered by smaller lenders it also means that customers circumstances may need to be more straightforward and maximum loan amounts will normally be lower than those offered by the largest banks.
Particular attention should be paid to the potential for stock market collapses and housing bubbles. In 2007, for example, the FTSE100 index was reaching a peak only previously seen before the dot com bubble and mortgage lending was at an all-time high.
Both strong indicators that a downturn was imminent. In this situation though, the risks for discount-rates were at their highest.
During the credit crunch, the Bank of England base rate dropped to its lowest ever rate yet most lenders variable-rates went up significantly.
A customer on a discount mortgage in this situation could have lost out very significantly to those on tracker rate or even fixed mortgages.
The discount-rate questionnaire; Are they for you?
So if you're considering a variable-rate mortgage then the more of the following questions you would answer yes to, the more likely they are appropriate for you.
- Do you think interest rates over the next few years are likely to remain low and stable?
- Do you think it unlikely that market shocks such as a stock market collapse or bursting housing bubbles are imminent?
- Is the difference in cost between the best fixed deals you can get and the best discounts enough to warrant taking the risk of increases?
- Could you afford increases to payments in the short to medium term and deal with budgeting for monthly changes in your payments?
- Are you quite open to taking risks?
- Is it unlikely you would be looking to move property during the discount period, or make very large overpayments (for example significantly more than 10% of the balance in a single year)?
- Is it unlikely you would be looking to raise large amounts of additional borrowing from the property for any reason during the discount period?
When are discount-rate mortgages a bad idea?
Discount-rate mortgages are generally a bad idea when the likelihood of big increases in interest rates is high.
It’s extremely difficult to determine this though, so the decision usually comes down to a risk vs reward decision for each customer.
If you cannot afford the risk of rate increases, or the benefit in terms of costs compared to fixed-rates is not significant they are a potentially a poor choice.
If the most competitive tracker products are similar in cost then again, the additional risks of a discount deal would likely not weigh up.
As they also tend to have early repayment penalties they may be less suitable for someone who could want to move home or sell the property during the discount period.
The same thing also applies to anyone likely to want to raise a sizeable amount of additional lending from the property during the early repayment charges and in these cases variable-rates or trackers without repayment penalties are an alternative that needs consideration.
As with all things though each case is different and so individual advice should be sought before making any decision.