In home loans, small is not beautiful

Taking out a modest mortgage can be the most expensive way of borrowing, says Stephen Pritchard

Rising arrangement fees hit borrowers with smaller loans the hardest. A £595 booking fee, by no means exceptional, represents more than one per cent of a £50,000 mortgage.

Several lenders also set their interest rates using tiers, which are related to the value of the loan. The larger the mortgage, the cheaper the interest rate. Borrowers looking for loans of £25,000 or less may find that some lenders do not want their business.

According to Paul Hearnden, of brokers My Mortgage Direct, lenders are most likely to offer "large loan discounts" on their standard or discounted variable rates. But some banks have interest rate tiers that also apply to their tracker and fixed rate mortgages. In some cases the difference is quite marked. Cheltenham & Gloucester has a two-year fixed rate mortgage at 4.39 per cent for loans more than £100,000. For smaller mortgages, the best rate is 4.79 per cent. For buyers looking for a small mortgage, a lender with a less attractive headline rate, but one that is on offer to all, borrowers, will be better value.

Mr Hearnden says that home buyers should look at the mortgage interest rate and the fees as part of the overall package. Buyers taking out a smaller mortgage will usually find that it is cheaper to pay a slightly higher interest rate in order to take a deal with low or no fees. If a mortgage is less than £100,000, he suggests, fees will be as much of a factor as the interest rate.

Borrowers switching lenders towards the end of their mortgage term might want to avoid fixed rate loans, which typically have high fees, in favour of a tracker or offset (current account) mortgage. Although the mortgage rate will be variable, with a relatively small loan the risk from interest rate movements is not as great, and such loans are often free of arrangement fees.

"Borrowers in the later years of their mortgages also tend to have larger savings balances," says David Hollingworth, from brokers London & Country. "An offset mortgage might work better, and these tend to be trackers." Borrowers can also take advantage of the way lenders tier their rates. If a mortgage amount is close to a tier threshold, it can actually be cheaper to borrow a larger amount. Most lenders now offer the option of making repayments of up to 10 per cent without penalty, so it is possible to pay the additional borrowing back almost immediately. But the remaining mortgage will still be at the higher rate.

At My Mortgage Direct, Paul Hearnden calculates that a home buyer could save £30 a month by borrowing just a few pounds more. "Cheltenham & Gloucester has a two or three year fixed rate at 4.39 per cent for loans of £100,000 or more," he says. For a loan of £99,000 the rate is 4.79 per cent. On £100,000 you would pay £365 a month, interest only and on the higher rate, that goes up to £395 a month."

A buyer could borrow the additional £1,000, pay it back but still benefit from the cheaper mortgage rate for the remainder of the deal. The arrangement fees are £200 higher on the £100,000 mortgage, but this is covered by the lower interest rate in under a year.

This approach will only work for borrowers who are at or near a lender's rate threshold for a better deal. It would make no financial sense to borrow an additional £30,000 or £40,000, just in order to find a slightly cheaper interest rate. Brokers also caution that most lenders' mortgage staff no longer give advice. This means that if a home buyer asks for a £98,000 loan, it is highly unlikely that they would suggest borrowing £100,000, even if it were cheaper to do so.

The answer may well be to turn to the local building society. "It does tend to be the building societies that are quite competitive, when you look at lower lending amounts," says Paul Hearnden. "But you should always ask the lender if there is a cheaper deal, for a mortgage at the next level up."

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