What is a mortgage?

What is a mortgage?

In short, a mortgage is a loan which you can use to buy land or property. For the average person, mortgages are very useful as very few people have enough cash to buy houses outright. For example, in the UK houses are on average £256,000 - that’s a lot of cash!

Where can you get one and how do they work?

You can get a mortgage from a bank or building society and pay back the amount you borrowed plus interest over a period of time. Interest is extra money which you pay to the bank or building society in return for them risking their money by lending it to you. It is calculated as a percentage of the amount borrowed. Mortgages can last anywhere from 6 months to 40 years, although the most common term length in the UK is 25 years. In the UK, it is very rare not to have to pay a deposit, which is at minimum 5% of the house price but it is usually 15%. This has to be paid as a lump sum at the start of your mortgage. The higher the amount of deposit you can pay in a lump sum, the better the interest rate you are likely to be offered by the mortgage lender. This relates to the Loan to Value. For example, if you put down a 10% deposit on the purchase price, the Loan to Value is 90%. However, if you put down a 25% deposit, the Loan to Value is 75%. The higher the deposit, the less risk the lender is making in case you fail to repay your mortgage (because they are more likely to get back the value of their loan even if the sell your home at below market rates if you fail to repay), which is why they are willing to offer lower interest rates for higher deposits.

Who can get a mortgage?

Not everybody can get a mortgage. The value of the property, your age, deposit, the length of the mortgage term, credit record, income and whether you are applying solely or jointly are all factors which will be taken into account by the lender in deciding whether to accept or deny your mortgage application. You can get a mortgage by yourself or jointly with others. Applying for a mortgage jointly means your incomes combine and you can apply for a larger loan.

What are the different types of mortgage?

The amount of interest you pay can vary with the type of mortgage you have. They can be split into either repayment or interest-only mortgages.

• Repayment mortgages are where payments pay back the interest as well as contributing to paying back the initial amount you borrowed. These are by far the most common type of mortgages in the UK. At the end of your term, if you have made all of your mortgage payments, you will have paid back everything you owe.

It is worth understanding that, at the start of your repayment mortgage term, you will be paying back more interest than capital. As you reduce the amount of capital you owe over time, you will end up paying back more capital than interest. The following chart illustrates this.

Repayment mortgages are usually either fixed-rate or variable rate.

·• Fixed-rate mortgages guarantee a certain interest rate, for example, 2%, for a period of usually 2 to 5 years. This gives you peace of mind as your payments will be the same every month, although your payments are usually higher than the variable rates. At the end of this 2 to 5 year period, you can either remortgage or it will be switched to the lender’s standard variable rate.

·• Variable-rate mortgage interest rates can change over the term of the mortgage and roughly follow changes in the Bank of England base rate. Variable rates themselves can be split into a few types.

• Standard variable rates are the normal interest rate your mortgage lender charges homebuyers. You can overpay or leave at any time.

• Discount mortgages are where they offer a discount off of their standard variable rate and only applies for typically two to three years.

• Tracker mortgages move directly in line with the Bank of England’s base rate plus a fixed percent. For example, if the base rate goes up by 5%, so will yours.

• Capped rate mortgages move in line with the lender’s standard variable rate but there is a guarantee it cannot rise above a certain level. This guarantee comes at a higher cost/interest rate.

• Interest-only mortgages are where payments only pay back the interest. No money goes towards paying back the initial amount you borrowed. However, you are still expected to pay back what you borrowed at the end of the deal in one lump sum. These are much less common in the UK than repayment mortgages. Borrowers have to save during the course of their mortgage to pay back what they borrowed. Interest only mortgages can be more attractive than repayment mortgages because, by their nature, they are lower cost and more affordable for people to be able to own their own homes. However, if interest only borrowers do not make any plans to repay the capital, even at the end of the loan period, they will not own their house and may be unable to secure another mortgage (dependent on their personal circumstances). They will continue to have to pay interest only which, in effect, makes it similar to renting. Any asset value they may have would be in the form of the increase in value of their property over time, which might make it easier to get lower interest rates from mortgage lenders. However, if the value of their house was less than the amount of mortgage they were paying interest on (negative equity), there would be problems refinancing a mortgage deal at the end of their mortgage term.

What is remortgaging?

Remortgaging is the process of switching from one mortgage to another in search of a better deal. For example, as previously mentioned, one may remortgage at the end of their fixed-rate term if they want to keep the peace of mind that comes with a fixed rate.

What happens if I don’t pay my mortgage back?

Typically, after 3 months of missed payments, foreclosure proceedings will start. This is where the lender will start legal proceedings to seize the house from you and sell it to try and make back the money which they lent to you. Your credit rating will also be affected if you miss mortgage payments or default (which means stop paying) on your mortgage loan. A bad credit rating would make it difficult to find another mortgage lender in the future, or if a lender was willing to lend to you they might only offer interest rates above the industry average to protect them in case you defaulted on the loan.

What type of mortgage is the best?

The concept of a mortgage is not very hard to understand but it can be difficult to decide what type of mortgage is best for your personal financial situation and/or stage in life. Getting advice from an independent mortgage broker (professionals who can help you to get the best mortgage deal for your personal circumstances) is a smart thing to do, because taking out a mortgage is a very important financial decision with consequences which last years.