Mortgage Penalties: Save now, but you will pay later

Even with today's relatively low interest rates, the prospect of a mortgage costing less than 2 per cent seems closer to fantasy than reality. But such loans do exist. The catch is that homebuyers who want to save now have to be willing to pay more later.

A decade ago, banks and building societies frequently offered fixed-rate and discounted mortgages with so-called "overhanging" redemption penalties. These penalties tied the homebuyer to the lender for a number of years after the end of the fixed rate. After the fix or discount, the mortgage would be charged at the lender's standard variable rate (SVR).

Overhanging penalties came in for much criticism and most lenders have dropped them from their mainstream fixed-rate mortgages. But a handful of mortgage companies still offer loans with overhanging penalties. The difference is that the best of these mortgages are significantly cheaper than a standard, two-year fixed rate.

According to Moneyfacts, the financial researchers, rates range from 1.79 per cent from the West Bromwich building society, to 1.89 per cent at the Leeds and 1.95 per cent at Portman. The best standard two-year fixed rates are just under 4.4 per cent.

But in return, homebuyers have to agree to stay with the lender for six years - or four years after the cheap rate ends - or pay a penalty. Redemption penalties start at 6 per cent of the mortgage. During the extended tie-in, the borrower pays the lender's standard variable rate or, in the case of the Portman loan, a tracker set at 1.99 per cent over the Bank of England's base rate.

As the building societies involved are anxious to point out, these loans will not suit every homebuyer. But there are circumstances where the low initial payments mean that these loans can be a useful tool.

Gary Brook, spokesman for the Leeds, says that a two-year rate is likely to suit first-time buyers or newly qualified professionals who expect their salaries to rise quickly.At the Portman, the group development director for mortgages, Matthew Wyles, sees interest at the other end of the market, including from investment bankers and senior doctors.

The Portman has also seen interest from buyers who plan to refurbish a property and who are willing to take a longer-term mortgage tie-in in order to cut outgoings during the work. At the Leeds, Mr Brook suggests that some borrowers are taking out mortgages with extended tie-ins now, with the expectation that interest rates might fall over the next two years. If that happens, the burden of the extended tie-in will be less, although this remains a gamble: rates could rise, rather than fall.

For this reason, the building societies stress that their affordability calculations are based on their standard variable or tracker mortgage rates, rather than on the initial, lower rate. Homebuyers who think that they can use a mortgage with an extended lock-in to go beyond the lender's standard rules for affordability should think again. "1.95 per cent is not a realistic rate on which to base affordability," cautions Matthew Wyle, at the Portman.

Using the higher rate that applies during the tie-in means that the borrower should not suffer "payment shock" when the discounted rate ends. Lenders also provide monthly repayment examples for both the two-year fixed rate and the subsequent variable rate period, so the homebuyer should know exactly what they are committed to pay.

Nonetheless, homebuyers should approach mortgages with tie-ins with caution, suggests Ray Boulger, senior technical manager at brokers John Charcol. He points out that some mortgages with extended tie-ins have rates that are not that much lower than regular two-year rates. The greatest risk is that homebuyers are committed to a mortgage with no protection against rises beyond the initial fixed period.

"You don't know what interest rates will be in five years' time," he says. "It's a risk that people often don't take on board."