Buying a house and taking out a mortgage represent the largest financial decision – and commitment – that you will ever make in your life. That’s why before you even start to think about getting a mortgage you need to understand how mortgages work and what kinds of mortgage might be right for you.
What Exactly is a Mortgage?
In simple terms, a mortgage is a loan that you can take out in order to buy a property (or occasionally some land). The loan that you take out will be secured against that property so that should a situation arise where you cannot repay the mortgage each month, your lender will step in and take back the property from you. The usual duration of a mortgage (in other words the length of time you agree to pay back the loan over) is twenty five years, although this can be extended or decreased.
How Do I Take Out a Mortgage?
In order to get a mortgage you will need to go to a bank or a building society or some other kind of specialist mortgage lender. They will then go through detailed checks of your financial situation and financial history in order to see whether you can afford to take out a mortgage. They will also do detailed checks on the property you wish to buy to make sure it is worth the amount that you are intending to borrow.
How Much Money Will I Need Up Front?
All mortgages these days require some kind of deposit. It was possible in the past to get 100% mortgages but these have long since disappeared post-credit crunch. The bare minimum these days is 5% (although this can currently be topped up with the government’s help-to-buy scheme). The mortgage that makes up the difference with your deposit is then expressed according to its percentage of the value of your new property. So, if you were to put down £5000 as a deposit on a £100,000 property then you would have put down 5% of the purchase price and the loan-to-value (LTV) would be 95%. However, the bigger the deposit you can save and put down, the better as your repayments will be smaller and you will be offered more favorable interest rates.
How Are Mortgages Repaid?
When you pay back a mortgage you are essentially paying back two parts – the capital, which is the sum you borrowed from the lender in the first place and the interest, which is the charge that lender has added to the capital. When you sit down to take out your mortgage you will need to decide how you want to pay it back. You can opt either for a repayment mortgage (the most common type of mortgage) that will pay back the capital and the interest, or an interest only mortgage which pays back the interest but which also needs a plan in place to pay back the capital at the end of the term. More details on the different kinds of mortgage can be found here.
Where to Look for a Mortgage
Wherever you decide to look for your mortgage, make sure you do your research first. For most mortgages you can use your high street bank, but don’t just go with your own bank and not shop around. This will be the biggest financial decision you ever make and it is important to research every product on the market. You can do this using online mortgage comparison websites and our own mortgage calculator.
Alternatively, you can approach a specialist financial advisor or mortgage broker who will be able to independently compare the different mortgage products on the market and evaluate your situation accordingly. Such a service is particularly useful (and important) if you are looking for a specialist or bespoke mortgage product such as a contractor or freelance mortgage or a buy-to-let mortgage.
How Much Can I Afford?
Before signing up to a mortgage it is essential to work out how much you can afford when it comes to mortgage repayments and how much you can borrow. Get this wrong, overstretch and you will end up falling into arrears and losing your home. Thankfully lenders now have to be much more strict in their criteria these days after new affordability regulations were made law on 26th April 2014. These affordability rules require that lenders must look at everything from proof of income to every one of your outgoings such as utilities, household bills, child maintenance, credit cards and personal expenses. In addition, potential lenders will also be looking ahead to check they think you will be able to continue making those repayments if interest rates rise and will find out about your future plans (such as retirement or babies) and anything that might affect you in the future. If they see anything that worries them then they might restrict the amount that you can borrow with them.
Before you make the application you should draw up your own budget planner outlining all of you income on one side with every single element of your outgoings on the other – as well as any future potential increase in outgoings. Once you have done this you should see if you can both afford the mortgage you are planning to apply for and also afford any increases to that mortgage which might come in future.
As you have probably already gathered there are all kinds of different mortgages on the market out there and it can often be difficult to work out which one is the best for you. The following should help point you in the right direction:
Interest-Only or Repayment Mortgages?
This first decision is actually quite simple – in spite of all the varieties of mortgage on the market there are still only two ways to pay back a mortgage, either through a repayment mortgage (which covers the capital loaned and the interest) or through an interest only mortgage, which repays just the interest. Most people will want to opt for the repayment mortgage, although occasionally it might suit someone to go for an interest-only mortgage
As mentioned above a repayment mortgage is a mortgage in which the capital and interest are repaid at the same time. It is the most common method of mortgage payment and is the only method that makes sure that you will be paying off the mortgage in its entirety by the end of the mortgage term (so long as you maintain all your payments).
Interest Only Mortgages
Interest only mortgages are mortgages in which you are only pay back the interest on your mortgage every month. At the same time, it is expected (and necessary) that you put in place an investment plan at the start of the mortgage that will mature and provide you with a lump some by the time the mortgage ends so that you can repay the capital too. This might be an ISA, and endowment policy or a pension (or any other kind of long term investment). Interest only mortgages are useful for people looking for lower monthly repayments; however, for most people, bearing in mind the uncertain nature of many long-term investments, a repayment mortgage will be the more secure option.
After you have made this decision it is time to go through all the different mortgage options available to you. The next choice is whether you want a fixed rate mortgage or a variable rate mortgage.
Fixed Rate Mortgage
Often called fixed-interest mortgages, fixed rate mortgages are mortgages in which the lender will set the interest rate at a fixed level for a pre-agreed period of time before it eventually reverts to their standard variable rate. Of course if you fix the rate at a certain level and then rates go up, you will have made a good decision – conversely if you set it and rates go down you might regret it! For more information on fixed-rate products click here.
Variable Rate Mortgage
If you don’t fancy getting tied into a fixed rate mortgage then you will prefer the variable rate mortgage. This will be a mortgage that sticks to the lender’s SVR (standard variable rate) or which tracks the Bank of England base rate and which can go up or down when those rates go up or down. For the pros and cons of variable rate mortgages, click here.