Kai asks: “I’m considering a 2,3 or 5 year fixed rate mortgage. Which of these fixed rate mortgage periods is best?”
Question 6 – Which Fixed Rate Mortgage Period Is Best? – Shownotes
Today’s question comes from Kai:
We are first time buyers and about to take out a £327k mortgage over 35 years. We’ve decided to go with a fixed rate, with a £999 mortgage fee, but we have an option of 2, 3 or 5 years.
The payments are:
2 year fix – 2.15%
3 year fix – 2.59%
5 year fix – 3.29%
Obviously, it’s a bit of a ‘look into your crystal ball’ question but we all know that interest rates are only going to go one way, right? It’s just a question of how quickly.
We can afford to overpay and the mortgage allows us to do so by 10% per year we will be looking to do so whichever one we will choose. We won’t be looking to move in the next 5 years if that helps any. Our combined income is ~£4,500pm.
Which one would you choose?
It’s a tough one.
Let’s assume that you have already decided on a fixed rate. The question is then whether you should opt for the 2 year fixed @ 2.15%, 3 year fix @ 2.59% and the 5 year fix @ 3.29%.
The difference in the interest rates for the three products model the banks’ expectation of what interest rates will do over that time. So, when you say rates will only go one way, that assumption is already built into these three rates.
Also, the “risk” premium is also built into these rates (i.e. the 3.29% is higher than it would normally be because the bank have to add a few extra 0.1%s in order to mitigate the fact that they don’t know what will happen over the next 5 years).
Therefore, because the expectation and protection against variance for the bank’s side is already built into the price, I personally tend to side for the shorter term fixes, with the plan to remortgage every two years on a new introductory offer.
There are two key things to consider here. Firstly, is that the current spread is high in my opinion. When I say spread, I’m talking about the difference between the rate at which banks borrow and what they lend at. In your question, the banks borrow at a current base rate of 0.5%, but lend on a 2 year fix at 2.15%.
I personally believe that due to future increases in competition and technology advances in the mortgage market (like we’ve already seen in other areas of finance such as P2P and low cost index funds), we’ll see this spread between base rate and lending rates fall. Therefore, when (if) the base rate goes up to 0.75%, I’m not sure that the 2 year fix will automatically follow suit and reach 2.4% in your example.
The second thing to consider is your actual example.
If you take out a 25 year £327k mortgage on the five year fixed rate of 3.29% (with an assumed SVR of 4.5% after), then your payments would be £1,486pm.
If you took out the same 25 year £327k mortgage on the two year fixed rate of 2.15% (with an assumed SVR of 4.5% after year 5), and you always keep your same £1,486pm payment, you’ll need your interest rate between year 3 and 5 (a 3 year fixed taken out when you finish your first 2 year fix) to be 4.05%.
The calculations can be found in the following spreadsheet:
The question is therefore whether you believe that you’ll be able to get a 3 year fix in 2 years’ time at 4.05% or less. If the spread from the base rate on fixed deals remains the same, it would mean that the base rate would need to increase by over 1.5% in the next 2 years. I personally cannot see that happening.
And then, one final thing we need to think about is your overpayments.
If you overpay 10% of your balance on a 2 year fixed, when you come to remortgage after 2 years, you may find that there are better rates available.
You currently have a property of £400k and a mortgage of £327k, implying a LTV of 81.75%. I’ve found an example site (Virgin) who currently offer a 2-year fix on an 85% LTV at 2.14% with a £999 fee (like you have).
If you were able to make overpayments of 5% of the balance in those first two years (which could be feasible given the net income you mentioned in your post), then your LTV may then fall to below 75%, which means that you may be eligible for lower rates.
Currently, with the same lender, you could obtain a 3 year fix for 2.29% at a LTV of 75%.
Therefore, when we previously said that your target interest rate for the 2 year + 3 year to equal the 5 year was 4.06% or less, the current 3 year in potential situation with 5% overpayments is 2.29%. That means that this rate would have to increase by 1.77% in the next two years (and maybe even further if I’m right about spreads coming down). Again, I don’t think that this will be the case.
To add an argument to balance it out slightly, you could argue in favour of the 5 year fix because of the stability. There is so mething appealing about knowing that you will pay X/mo for 5 years regardless of external conditions, and that you don’t have to go through the hassle of remortgaging again in two years. Also, we’ve built the £999 mortgage fee into our calculations, but there might potentially be lower or greater costs for arranging a mortgage in the future – something else you’d need to consider.
However, with that stability usually comes a restriction of freedom. In the five year fixed rate mortgages, you’ll often have a clause whereby an overpayment of more than 10% (which will come in if you need to move house because you got offered your dream job somewhere else) will come with a % fee. This could run into the tens of thousands with a £327k mortgage, and so is also something you want to add into your decision process.
For me personally, because of the way I’m wired – maths outweighs psychology – and I would personally opt for the 2 year fix at 2.15% and start making those overpayments.
Maybe in two years’ time, the base rate has shot up to 3%, banks are now charging 5% for their 3 year fixed rates and house prices have tumbled 20% and hence your LTV will be higher when you remortgage in two years. In that scenario, you’d be laughing if you’d taken out the 3.29% 5 year fixed rate. But, that’s the risk you take…
I suggest that you do all this maths, think about all your options and then go and have an open discuss with an independent mortgage advisor to see if they can add anything else to your thoughts. However, make sure that you lead that discussion with your numbers (take Excel into the meeting) so that the advisor won’t be tempted down a route which leads to more profits for them…
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