Beware Of This Tracker Mortgage Trick

When tracker mortgages don't do what it says on the tin...

When is a tracker mortgage not a tracker mortgage?

This isn't a trick question. Worryingly for borrowers, there are conditions written into some tracker deals which mean they don't always work the way you might think.

Typically, mortgage lenders offer a tracker at a set margin above or below the Bank of England base rate. So your tracker rate might be 2% higher than the base rate (BBR +2%). That means, today, when the base rate is 3%, your mortgage interest rate would be 5%.

If the base rate fell to 2.5%, the interest rate on your tracker should, in theory, drop from 5% to 4.5% and you'll be quids in! 

But, on the downside, if the base rate increased to 3.5% instead, your tracker rate would rise from 5% to 5.5% making your mortgage repayments more expensive.

Not surprisingly, tracker mortgages are pretty popular right now because it looks like further base rate cuts are on the cards. Experts certainly agree reductions are likely with some predicting the rate could fall as low as 2% -- or even 1% -- next year. (But, of course, there are no guarantees.)

If you're on a tracker deal you probably think this is fantastic news, but before you get too carried away, watch out for this sneaky tracker trick:

Collars

If you have a tracker mortgage, you probably think your mortgage interest rate will automatically rise and fall in line with changes to the base rate. But this isn't necessarily so. Some lenders have written a condition into the mortgage deal which allows them to stop passing on cuts to borrowers once the base rate has fallen below a certain point. This is known as a `collar' or `floor'.

And it's looking increasingly likely that collars may start to kick in on some tracker deals given the dramatic cuts to the base rate last month.

What does this mean for your tracker mortgage?

Where collars apply, they often come into play when the base rate reaches 2.75% or 3%.

Let's say your tracker deal has a collar of 3%. This means that no matter how low the base rate falls, the lender will always calculate your interest rate as though the base rate was at least 3%. 

So if the base rate drops 0.25% to 2.75%, your interest rate will stay the same. You won't ever benefit from any further falls in the base rate and your monthly repayments will not decrease.

What if your tracker falls below base rate?

You may have a tracker deal that tracks at a margin below the base rate - for example, base rate minus 0.5%, giving you a current rate of 2.5%.

A 3% collar may still apply. Remember it is a collar on the base rate, not your actual mortgage rate. So if you have a 3% collar, any further cuts will not be passed on.

How do collars work in practice?

Thankfully, not all tracker deals have collars, but it's worth checking out whether your deal does if you're an existing borrower, or you're about to apply for a new tracker. Collars vary from lender to lender. Here are just a few examples:

Nationwide offers a two-year tracker mortgage deal which tracks the base rate at a margin of 2.19% (so currently 5.19%). This deal has a 1% collar, which means the rate the borrower pays can't fall any lower than 3.19%. This won't be a problem as long as the base rate doesn't drop below 1%. If it does, borrowers won't benefit from further rate cuts.

Worse still, Skipton Building Society has a collar of 3%. That means the lender's tracker mortgages won't get any cheaper than they are now. Another base rate cut would have absolutely no effect on existing borrowers' repayments. (Skipton has currently withdrawn its tracker range to new borrowers.)

Halifax's collar could be pretty unfair to borrowers if the lender chooses to put it in place. Halifax tells us it reserves the right to review its tracker margins if the base rate falls below 3%, and may apply a collar at that time. But, unusually, it also has the right to pass on any base rate rises while the collar is in place.

So how could this work in practice? Using Halifax's two-year tracker deal as an example, borrowers are currently paying a rate of 4.89% (BBR+1.89%). Now let's say the base rate fell by 0.25% to 2.75%. Instead of paying a new, lower rate of 4.64% borrowers would still pay 4.89% if Halifax chose to put the collar in place. 

But if the base rate then rose 0.25% again to 3%, the lender could choose to pass on the base rate increase - even though they'd never passed on the original cut!

This means the rate borrowers pay could go up from 4.89% to 5.14% to include the quarter point rate rise. So the margin would then be 2.14% above the base rate, rather than the 1.89% it should be, even though the base rate is back at 3% and above the level at which the collar could be applied.

Meanwhile market-leading tracker lender, HSBC, says it reserves the right to stop passing on base rate cuts following a `material change' in the mortgage market. Although the lender is keen to reassure borrowers that it intends to apply further reductions -- at least in the short-term.

Read the small print...*

Fools will know how often we rant on about reading the small print before committing to any financial product -- and with good reason. It's a huge disappointment for tracker borrowers to find out that a collar could put an end to the prospect of cheaper repayments.

But even if you find a sneaky collar lurking in the terms and conditions of your deal, you don't have to put up with it. You always have the option to switch to a new deal that doesn't have one.

But, before you switch, check out any early repayment charges on your current mortgage, as well as the new rate you'll be paying and the fees for remortgaging. Speak to a broker at The Motley Fool Mortgage Service who can help you decide if you could be better off with a new lender.

*In a speech at the Council of Mortgage Lenders Annual Conference yesterday, Jon Pain, Managing Director, Retail Markets, Financial Services Authority (FSA) said collars on trackers mortgage could be a legitimate term on the mortgage deal but only if it is made clear to the consumer and spelt out in the initial Key Features Illustration and offer document. Lenders who fail to do this run the risk of breaching the FSA's disclosure requirements and having an unfair contract term which can't be enforced. 

More:  Six Marvellous Mortgage Trackers | Visit The Motley Fool Mortgage Service