Over the course of your life you’ll likely take out a variety of loans for all sorts of reasons. Chances are, however, that the biggest loan you’ll take out – and the biggest financial commitment you’ll make – is a mortgage.
This guide explains how a mortgage works, from what it is, to how much it costs and why, to how to go about getting one.
What is a mortgage?
A mortgage is a type of loan designed to buy property or land. It’s paid back over a longer term than other loans, typically 25 years, and is secured against the asset itself. That means if you don’t or can’t keep up the payments, the lender may take your home and sell it to pay off the outstanding debt. You’ll be given anything that’s left after that.
How do mortgages work?
The chances are you don’t have the money to buy a property outright. That means when you find somewhere you want to buy, you’ll have to borrow some money.
You’ll have to put down a deposit – anything from 5% upwards, with 10% being typical. When you’re accepted for a mortgage, the lender will loan you the rest of the purchase price. The lender charges fees for arranging the mortgage and interest on what you owe.
The deposit is an important factor in a mortgage. The bigger the deposit you are able to put down, the less you have to borrow, and so the lower the monthly repayments will be. You’ll probably also qualify for a lower rate of interest.
The main driver for this is the loan-to-value ratio, or LTV. If a lender gives 90% of the purchase price they are exposed to a bigger risk if the payments aren’t kept up than if they loaned 75% of the purchase price. In the latter case they have a better chance of making back their money on sale of the property.
Paying off a mortgage
There are two ways to pay off a mortgage – repayment and interest only.
With a repayment mortgage you pay some money off the capital (the amount you borrowed) and also the interest every month. At the end of the term of the mortgage, there is nothing left to pay. This is the most common type of mortgage.
With an interest-only mortgage, you only pay the interest every month. You must have some means of repaying the capital at the end of the mortgage term, when it all becomes due in one payment. This might be a savings or investment plan, another financial product, or selling the property, but proof of the exit plan will often need to be provided in order to get the mortgage in the first place.
Beyond repayment or interest-only mortgages, there are different types of deal. For example, there’s fixed interest rate, where you pay the same amount of interest on the loan for an agreed period of time, or variable interest rate, where the interest rate changes in line with the Bank of England base rate, meaning your payments also change.
How do I know which mortgage I need?
This will depend on your own personal circumstances. For example, if you need the certainty of a fixed monthly payment, then a fixed-rate mortgage will give you that. Fixed interest rate deals usually last for a set amount of time, after which you go onto the lender’s regular mortgage or else negotiate another deal. Be aware that if you see a better deal and want to end a fixed-term agreement early to take advantage of it, you might have to pay a penalty fee.
If you have a bit of flexibility you might be prepared to take on a variable rate. That means you can pay less if interest rates come down, although you’ll have to pay a bit more if they go up.
How are mortgage repayments calculated?
Mortgage repayments are calculated using an algorithm that incorporates the amount of the loan, the term and the interest rate. The easiest way to see what your payments are likely to be is to use an online mortgage calculator.
With a repayment mortgage, more money goes against the interest than the capital in the first few years, but over time the balance starts to shift and you’ll see the amount of capital owed begin to drop more steeply until the loan is repaid and you are mortgage-free.
How much can I afford?
Make a list of all your outgoings including a contingency in case something unexpected happens. You can deduct rent, if you are currently paying it. Next, add up your sources of income and look at the difference between the two figures; that is how much you have available for your mortgage.
Don’t put yourself in a position where you are stretched too thin; you need to be able to live your life as well as pay your mortgage. You can usually borrow up to 4.5 times your income.
A lender will ask for proof of income and outgoings and assess whether they think you can afford to pay back the loan you have asked for. They may say yes, or offer a smaller amount, or say no, if they think you can’t afford it.
How do I apply for a mortgage?
You can approach a high-street lender directly or else take advice from a mortgage broker. An independent mortgage broker with an extensive network of lenders will be able to offer you many more options than a broker with limited market access or a specific lender, such as your bank, which will only offer you their own products.
When you are making such a huge financial commitment, especially if you’re a first-time buyer, taking independent advice is highly recommended. What may seem a small saving mounts significantly up over time.