Choosing how the interest on your loan will be calculated is a crucial part of selecting your mortgage and can be quite confusing for someone new to the subject. The interest rate can either be fixed at a set rate or can vary in accordance with changes to the Bank of England base rate. 

The Bank of England base rate is set by the UK Monetary Policy Committee which has a mandate to keep inflation at around 2%. The Bank of England will adjust the base rate  if inflation starts to move much higher or lower than this figure.
 
A mortgage provider’s most basic type of loan will be based on its standard variable rate (SVR) and will move in line with changes in the base rate.

However, unless you have a poor credit history this usually won’t represent the best deal and the real choice will be between taking out a fixed rate mortgage or taking a discount rate mortgage. A discount rate mortgage also varies in line with the base rate but is a certain percentage below the lenders standard variable rate.

Fixed Rate Mortgage 
 
A fixed rate mortgage means that you to pay exactly the same interest rate for an agreed number of years. The agreed rate of interest will depend on the current base rate but will also depend on where the mortgage provider thinks the base rate will move to over the life of the deal.
 
Choosing this option means that you know exactly how much the mortgage will cost every month and you face no nasty surprises if the base rate rises.

However it also means that you won’t benefit if the base rate falls and you could be stuck on an uncompetitive rate.  
To prevent you simply remortgaging and choosing a different deal when the base rate falls your mortgage provider will impose an early redemption penalty if you want to get out before the end of your agree deal.
 
Read more about early redemption fees here.

Discount Rate Mortgage 
 
A discount rate mortgage means that you to pay interest at a ‘discount’ to the mortgage provider’s standard variable rate. For example if the lender’s standard variable rate is 7% they may offer a discount rate of 4%.
 
Like a lender’s standard variable rate mortgage a discount rate mortgage will move in line with changes in the base rate.
 
For example if the base rate moves from 1% to 2%, your mortage interest rate could change from 4% to 5%
 
The discount rate will last for an agreed number of years, after which you will normally be transferred over to the lenders standard variable rate – at this point you may consider remortgaging to find another good discount deal.
 
If you want to get out of the deal you will face an early redemption penalty while the discount is in place. Some providers will extend this penalty beyond the length of the discount period so as to keep you on their uncompetitive standard variable rate.
 
This is an important consideration when choosing a discount rate mortgage and you should read more about it here.
 
The advantage of a discount rate deal is that you will benefit if interest rates falls but conversely if interest rates rise you will face paying more for your mortgage and have to find more each month to fund your repayments.

Which to Choose 

It is very difficult to predict where interest rates will go (see a historical overview of the Bank of England base rate here). Therefore if your repayments are near the limit of what you can afford it may be wise to choose a fixed rate deal so that you can be sure of meeting the repayments if interest rates rise.
 
However, if you believe that interest rates will fall and can afford to pay a bit more each month if this turns out not to be the case then a discount rate mortgage may be the better option.
 
At the moment the Bank of England base rate is already very low (at just 0.5%). Therefore interest rates have virtually nowhere left to fall. A fixed rate would therefore be the better option all things being equal. However, the decision is complicated by the fact the fixed rate deals you are likely to offered will have an interest rate that is higher than the discount rate deals (because lenders assume that interest rates will rise in the future)

The judgement to be made is therefore not whether you think interest rates will fall but instead how long you think the Bank of England base rate will remain at the current very low level.
 
This will depend on how quickly the UK economy recovers and the extent to which government measures to stimulate the economy (such as the difficult to say ‘quantitative easing’) have the unintended consequence of stimulating inflation.