Page last updated at 10:21 GMT, Tuesday, 24 April 2007 11:21 UK

Understanding different mortgage types

A maze
The mortgage market is a bit of a maze

Mortgages should be straightforward - you borrow money to buy a house and pay interest on the loan.

But after a few enquiries, you soon realise that it's not so simple after all.

In a hugely competitive market, building societies and banks are continually updating and extending their range of mortgages. The list is already extensive enough to baffle all but the most determined.

The most important points are how you pay back the capital you borrow and how you pay the interest on it.

Paying back the capital

You can either pay a little at a time as you go (repayment mortgage) or pay it all off at the end (Interest only or endowment mortgages).

Repayment mortgages - Each monthly payment pays off a little of the underlying debt, as well as interest on the loan. At the end of the term the mortgage is cleared.

This is widely considered to be the most easy to understand and least risky mortgage type. But remember if you do not keep up with repayments the lender can repossess the property.

Interest only mortgages - With this type of mortgage, you pay-off the interest on the loan but not the capital. At the end of the mortgage term you are expected to repay the capital, how you fund this is your business.

Interest only mortgages have grown in popularity in recent years amongst buy-to-let investors and first-time buyers in particular because, put simply, they are cheaper than a repayment mortgage.

However, some experts are concerned that many people taking out an interest only mortgage are not giving enough thought as to how they will repay the capital.

Endowment Mortgages - You use an endowment policy to provide life insurance and save funds to repay the loan at the end of the term (usually 20-25 years).

If the investment performs badly, you could face a shortfall on your loan at the end of the repayment period. In the 1980s endowments were very popular and heavily marketed by lenders.

However, many people were not told of the investment risk. This was mis-selling and lenders faced huge claims for compensation.

As a result, endowment mortgages have declined sharply in popularity. Relatively few endowments are sold today but there are still millions of policies yet to mature.

Mortgage application forms
Remember to read the small print

Paying the interest

You have to pay interest on any debt, and mortgages are no different. They differ only in the range of options offered.

Variable rates - This means you pay the going rate on your loan. The mortgage rate changes every time interest rates change or, as in most cases, the overall effect of any interest rate changes is calculated once a year and payments are altered accordingly. Whatever kind of mortgage you start with, it is likely to change to variable rates at some point.

Fixed rates - The interest rate is fixed for the period agreed - often two to five years. These are ideal for budgeting or if you think rates might increase. You do not benefit if rates fall, and will face penalties if you try to quit.

Very low rates may tempt you, but they can be used to trap you into paying over the odds at a future date. Check how long you will have to stay with the lender before you can switch without penalty.

Capped rates - These are fixed, but if rates fall you pay the lower rate. Such deals can be a good for budgeting.

Cash back deals - This is when lenders offer money back if you take out a particular product. However, nothing comes free in life and cashback mortgages may be weighed down with hefty penalty charges if you later want to switch lender.

Discounted rates - Under this type of mortgage the borrower is offered a discount off the lender's variable rate. The rate paid will fluctuate in line with changes in the variable rate. The discount applies over a set term.

TEN KEY QUESTIONS
The government suggests mortgage customers should ask these 10 questions.
How much can I afford to borrow?
How can I tell which mortgage rate is best?
What is the best type of mortgage for me?
How should I repay it?
Can I make lump sum payments?
Are there any redemption penalties?
Does this mortgage come with insurance?
What other charges will I have to pay?
What happens if I can't pay?
What about the small print?

Key facts documents

Mortgage providers are now legally bound to present customers with a key facts document.

The Financial Services Authority (FSA), which regulates mortgages, says the key facts document should deliver clear, simple and user-friendly information to consumers about the mortgage offer.

The key facts document sets out the total cost of the loan - not just the headline interest rate - including any up-front fees.

Mortgage fees have been rising of late as providers reduce their headline annual percentage rates to attract new business.

Each new mortgage customer has to confirm that they have received the key facts before putting pen to paper.

The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.



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