Depending on which house price indicator you follow, the average price of a UK property now costs in the region of a quarter-of-a-million pounds.
With such a substantial sum in mind, it’s important for anyone thinking of climbing on to the property ladder to understand how mortgages work.
There are already a lot of home loans around. According to the latest English Housing Survey (2019-20) there are an estimated 23.8 million households in England.
Owner-occupiers make up about two-thirds (65%) of this figure. Out of this group, those who own their properties outright only slightly outnumber households with a mortgage.
What is a mortgage?
Unless you have very deep pockets, or have inherited a pile of bricks and mortar, the chances are you’ll need a mortgage to buy your first property.
A mortgage is simply a loan used to buy a property. A deposit is required to pay for a portion of the property yourself, while the remaining amount will be covered by the mortgage.
The amount borrowed (the capital) is then repaid by the borrower in monthly instalments over a period of around 25 years. Monthly payments include interest as charged by the lender.
As the mortgage will be secured against your property, the lender will have the right to repossess your home if you are unable to repay the amount borrowed.
What’s a deposit?
A deposit refers to the amount of capital you put down to buy the property.
You’ll need a deposit of at least 5% of the property price to get started. But the more you can put down, the easier it will be to secure the best mortgage rates. The cheapest deals typically require a deposit of around 40%.
When comparing mortgages, you’ll come across the term ‘loan-to-value’ or LTV. Expressed as a percentage, this figure refers to the proportion borrowed on a mortgage against the value of the property.
For example, if you put down a deposit of £25,000 on a property worth £250,000, you’d need to borrow £225,000. Your deposit size would be 10% and your LTV ratio would be 90%.
To calculate your LTV, divide your mortgage amount by the value of the property. Then multiply this figure by 100.
Repayment or interest-only?
Repayment mortgages are the most common. They allow you to pay back a portion of the original amount borrowed, plus interest, in each monthly repayment.
With an interest-only mortgage, you only pay back the interest on the amount you’ve been loaned each month. This means your monthly repayments will be lower. But at the end of the mortgage term, you will need to find a way to repay the total amount originally borrowed. By building up a sum in a savings plan, for example.
Lenders will want to see watertight evidence that you have a repayment strategy in place before offering you an interest-only mortgage.
What are the main types of mortgage?
Mortgages come in several versions, usually categorised by how the all-important interest rate on the home loan is determined. They include:
Fixed-rate where the loan’s interest rate and, therefore, your repayments remain the same for the length of the deal (typically two, three or five years).
Variable the interest rate on these mortgages are subject to change at any time. There are two main types of variable mortgage: tracker and discounted.
Tracker: the interest rate follows an economic indicator, usually the Bank of England’s base rate. Repayments will rise or fall in line with whether the base rate goes up or down. Tracker deals tend to last two to five years.
Standard variable rate (SVR): at the end of a fixed-rate or variable deal, you’ll be put on your lender’s SVR. This is unlikely to be competitive, so it’s important to move to a different deal as soon as possible.
Discounted: you pay the lender’s SVR, with a fixed discount for two to three years. For example, if the bank’s SVR is 5% and the discount is two percentage points, a borrower would pay an interest rate of 3%.
Offset: savings accounts are linked to your mortgage and the value of your savings is deducted from the amount you pay interest on. You won’t earn interest on your savings, but you will save interest on your mortgage.
How to get a mortgage
Mortgages are offered by banks, building societies, and other specialist lenders. Being such a major commitment, it’s more important than ever to shop around for a mortgage and compare your options first.
An online affordability calculator will provide an estimate of how much you can afford to borrow based on your income and outgoings. It will also tell you what your monthly payments will be across a range of interest rates and scenarios.
For example, if you put down a 10% deposit to buy a property worth £250,000, you’d borrow £225,000.
Plug in some figures and a repayment mortgage over 25 years with an interest rate at 4% would cost £1,187 a month. If the rate was 3%, you’d pay £1,067 a month.
Making your application
You can apply directly with your chosen lender, via a comparison website, or through a mortgage broker. At this point, the lender or broker in question will carry out a more detailed affordability assessment.
Since the introduction of the Mortgage Market Review in 2014, lenders are more rigorous with their checks and will scrutinise your income and outgoings carefully.
They will also ‘stress test’ your finances to see if you could still afford a mortgage if interest rates were to increase.
As part of your application, you will be asked to provide the following documents:
- Bank statements for the past three to six months
- Your last three months’ payslips
- P60 form from your employer
- Proof of ID, such as your passport or driving licence
- Proof of address, such as a council tax bill or utility bill.
If you are self-employed, you’ll need two or more years of certified accounts as well as SA302 forms, or a tax year review from HMRC for the past two to three years.
The importance of credit scores
Lenders will use your credit score to determine how reliable you are as a borrower before agreeing to offer you a mortgage.
The better your credit score, the more likely you are to get accepted and secure a competitive interest rate.
To be prepared, it’s a good idea to check your credit score yourself before you apply by using one of the fee-free services available online.
If your score is low, take steps to improve it such as checking you’re on the electoral roll, correcting mistakes on your credit report, paying bills on time and spacing out any other new credit applications.
Should you use a mortgage broker?
Mortgage brokers can help you scour the market for the right deal, assess your affordability, and match you with the lenders most likely to accept your application.
Many brokers won’t charge you directly for their services. But check their independence and that they have access to as large a proportion of the mortgage market as possible (rather than just a few selected lenders).
Where does your money go?
When applying for a mortgage, you’ll also need to pay a range of fees. These can include:
- Booking or application paid when completing your application
- Arrangement charged by your lender to set up your mortgage
- Valuation charged by your lender to commission a mortgage valuation
- CHAPS for sending mortgage funds to your solicitor
- Legal charged by your solicitor to carry out legal work for the mortgage
Booking and arrangement fees can often be added to your mortgage balance if you’d prefer not to pay them upfront. But this will increase the total amount owed and the amount of interest due.
Don’t forget also to set aside funds for moving costs as well as Stamp Duty Land Tax. Stamp duty is a tax levied on buyers determined by the value of the property being bought. In Scotland, it is formally known as Land and Buildings Transaction Tax, while in Wales it’s called Land Transaction Tax.
Many mortgages have a tie-in period which means you are locked in for the stated term. For example, if you choose a two-year, fixed rate deal that’s for how long you’ll be tied in.
Should you want to get out of your mortgage deal early or pay back the whole loan before the end of the agreed term, early repayment charges (ERC) will usually apply. ERCs are charged as a percentage of the outstanding mortgage balance, often between 1% and 5%.
ERCs are often tiered so that the closer you get to the end of the tie-in period, the less you pay.
How easy is it to switch mortgage deals?
Jumping ship and switching lenders is referred to as ‘remortgaging’, while staying put with the same lender but switching deals is known as a ‘product transfer’.
Either way, when your existing mortgage deal is nearing its end, you’ll need to look at your next best option in order to avoid reverting to your lender’s expensive SVR.
The process of remortgaging is similar to taking out your first mortgage in that you’ll need to shop around and compare options to find the best deal to switch to. Many remortgages come with free legal and valuation fees, but you’ll need to pay any new arrangement fees.
Switching products with the same lender is usually a quicker process, although your current lender may not offer the best deals.
What happens if you can’t keep up with mortgage repayments?
If you’re struggling to keep up with your mortgage repayments, contact your lender as soon as possible. It may agree to extend the term of your loan to reduce your monthly payments, or accept smaller payments for a temporary period.
You may also be offered a mortgage payment holiday so that you stop making payments for an agreed period. Just bear in mind that any unpaid payments will be added to your overall debt, on which interest will be charged.
In the worst-case scenario, your lender can take you to court and repossess your home. But it’s in the interest of all parties to avoid this scenario if at all possible.
Top tips for securing the best mortgage
- Save up as much of a deposit as you can
- Understand how much you can afford
- Check your credit score and take steps to improve it
- Pay off debts such as credit cards and overdrafts
- Sort out paperwork early, particularly if you’re self-employed
- Shop around and compare deals
- Consider using a mortgage broker
- Don’t overlook all the extra costs associated with home loans.