How do Mortgages Work?

Here's everything you need to know before applying for a mortgage...

October 29, 2020

Mortgage documents

Fixed rate? Tracker? Interest only? 25 years or 30 years? Getting a mortgage can be a minefield, with important decisions to make at each turn. Our complete guide to how mortgages work is here to simplify the process for you...

With the price of houses being so high, the vast majority of us will never be able to afford to buy a home with cash. Instead, we have to take out mortgages and then pay them back over time.

It is likely that your home will be the biggest purchase you’ll ever make, so it pays to do your research to find out the different types of mortgages on offer and understand your affordability before jumping straight in.

But how exactly do mortgages work, what are the different options available and how do you go about getting a mortgage? We explain all you need to know here.

Why do you need a mortgage?

house for sale signsToday, buying a house is more expensive than ever and there is nothing to suggest that UK house prices will be dropping anytime soon, so it is inevitable that you will have to take out a large loan in order to pay for it - this is known as a mortgage.

Average house price UK

According to HM Land Registry’s UK House Price Index, the average cost of houses is now £239,196 as of August 2020. This has increased by 2.5% in comparison to the cost of houses last year (2019).

This price is not far off eight times the average UK annual salary of £30,350 - so it's fair to assume that buying a house outright with cash is out of the question for many people.

That's where mortgages come in, which, for many people, is the largest type of loan they will ever commit themselves to in their lives.

A mortgage is a type of loan that you can take out via a bank, building society or mortgage broker, which can then be used to pay for a house.

How to get approved for a mortgage

In order to get approved for a mortgage, you will have to pay a deposit to make up a certain percentage of the value of the house, which is typically between 5% and 20%.

The mortgage will then take care of the rest of the value of the house, which you will pay off on a monthly basis (including interest) over a certain pre-defined period (usually 25, 30 or 35 years).

When you've paid off the whole mortgage at the end of this period, you will then own the house outright.

Keeping up with your repayments is important - if you don’t, you risk having your home repossessed by your lender to cover their costs.

Mortgage payment options - interest only vs repayment

There are traditionally two main options when it comes to paying back your mortgage - repayment mortgages and interest-only mortgages.

Repayment mortgages are much more common today, as these require the house-buyer to pay back part of the amount borrowed each month - plus any interest. This type of mortgage is structured so that by the end of the specified repayment term (normally 25, 30 or 35 years) you will own the property outright. Therefore, the amount you pay back each month will depend on the length of the mortgage term.

With an interest-only mortgage, you would only pay back the interest that had accrued each month, and then pay the full amount of what you borrowed from the lender at the end of the specified mortgage term. The monthly repayments work out much cheaper, but it is very rare for mortgage providers to provide an interest-only mortgage these days.

Ever since the financial crash of 2007, banks and building societies have been a lot more cautious regarding interest-only mortgages, and need to be certain that you would be able to afford to pay such a big lump sum at the end of your mortgage term. Common methods of raising the funds to pay off an interest-only mortgage include cashing in on stocks and shares, savings plans, pensions or investment bonds.

For these reasons, a repayment mortgage is generally the most popular way of buying a home.

How do buy to let (BTL) mortgages work?

Buy-to-let mortgages work in a similar way to standard mortgages, but there are some significant differences between the two that you should be aware of.

This type of mortgage is only suitable for people who are looking to buy a property for investment reasons and are not buying it with the intention of living there.

For those who are planning on becoming a landlord and renting out a new property, the majority of lenders will require buyers to get a buy-to-let mortgage instead of a standard residential mortgage.

In order to be eligible for a BTL mortgage, you will need to pay a deposit of between 25% and 40%, and it is worth noting that fees tend to be higher for this type, so they are generally more expensive than standard mortgages.

In general, most BTL mortgages work on an interest-only basis, meaning that the buyer only has to repay the interest every month, not any money from the original loan taken to buy the property initially. At the end of the term, whether that’s 20 years or 35, the buyer will need to pay a lump sum that covers the full amount of the mortgage.

For those who don’t want an interest-only mortgage, there are lenders available which offer buy-to-let mortgages on a repayment basis, rather than interest-only.

Different types of mortgage rates - Fixed, variable and trackers

When you start looking into mortgages and the different types of deals on offer, you are immediately inundated with different interest rate offers for Fixed, Variable and Tracker mortgages.

Fixed mortgage

A fixed rate mortgage is one that, unsurprisingly, has a fixed rate of interest throughout the entire term and won't ever be subject to change. These are good if you like to know exactly how much you will be paying towards your mortgage each month so that you can budget accordingly.

Standard variable mortgage

Another common type of mortgage is the Standard Variable Rate (SVR), which is usually what lenders will put you on after your initial rate deal has expired (after the first two years, for example).

Each mortgage lender has their own standard variable rates that they set themselves, which they can decide to increase or decrease at any time (hence the name ‘variable’).

This is often not the most cost-effective rate and could leave you paying a lot more than you need to, so it’s important that you switch your mortgage when your initial rate deal expires (usually 1 – 2 years).

Tracker mortgage

Tracker mortgages are also a form of variable rate which generally follows the Bank of England's (BoE) base rate of interest and usually, a small percentage is added on top of this. You need to be aware that this could change though, with any significant rise in the base rate leading to much higher mortgage payments.

As a general rule, tracker mortgages tend to incur lower fees than those charged for fixed-rate ones.

It all basically depends on whether you prefer the stability that comes with a fixed rate mortgage, or you want the flexibility of tracker mortgages.

Mortgage eligibility

Before you get to the stage of applying for a mortgage, you will need to have a few things ready at your end.

Most mortgage providers will require you to have a deposit of at least 5% of the value of the house - but the higher the deposit the better deals will be available to you. Lenders use the Loan to Value (LTV) ratio to assess the risk of lending to you, so the lower the amount of loan compared to the value of the house, the less risky a proposition you will look to them.

You should also aim to have a good credit score before you apply, as this will also have a bearing on how much of a financial risk it is to lend to you - so pay off any debts, stop applying for any form of credit (credit cards, store cards, car finance etc...) and make sure you are on the electoral register.

During the mortgage application process, lenders will require evidence of your income and outgoings. Usually you need to show them your last three month's payslips to show your income, and your last three months of bank statements to show your outgoings. It is therefore a good idea to avoid any excessive spending in the run-up to applying for a mortgage, as some lenders can be quite strict in this respect.

Additionally, if you are applying for a joint mortgage, they will also have to check the eligibility status of the other person you are getting a mortgage with.

Check your score now to see how eligible you are for credit:

Do I need insurance to get a mortgage?

Life insurance

It’s worth taking into consideration that you may need to get life insurance when taking out a mortgage.

Purchasing life insurance is not compulsory, but many lenders will insist that you have a policy in place before you move into the property, as this gives them the reassurance that all costs will be covered in the event of your death.

People generally put a life insurance policy in place (usually decreasing term) to cover the cost of your mortgage should you pass away.

Not all providers require buyers to have this in place before moving in, but some lenders may be more inclined to let you borrow if you do this.

Home insurance – Buildings, contents and combined

The only insurance that is legally required when buying a house and getting a mortgage is buildings insurance, because this covers the cost of any damage done to the building (walls, roof, floor, etc).

Your lender will need to know that you have this type of policy in place because if something happens, like a fire, the value of your house would decrease if you didn’t have a buildings policy in place to cover the costs of repairing it. This then means that the house isn’t worth the original value that you borrowed, and the lender would struggle to get the money that they owed you back.

Ultimately, this is required to protect the risk that lenders are taking when lending such significant amounts of money.

Contents insurance is a separate policy that covers all the items in your home, such as your furniture, gadgets, etc.

Many people will choose to get a combined buildings and contents home insurance policy so that they’re fully covered – and because it often works out cheaper than getting two separate policies.

Read more:

How much can I borrow?

When deciding how much you can borrow, the mortgage provider will assess your salary, outgoings, credit score, address history and everything else they think could influence your ability to pay them back. As a general rule, lenders will be prepared to lend you around four or five times your salary - as long as you pass the credit check side of things.

There are many mortgage calculators you can use online, but these will only give you a broad 'ball-park' figure based on the basic information they require. In order to get a clearer view, you need to speak directly to a mortgage broker or mortgage provider.

These days, lenders are required to run 'affordability assessments' on mortgage applicants to make sure they are able to afford repayments if interest rates were to rise or personal circumstances were to change. Therefore, things like your spending habits, financial dependents, current debts, pensions etc... are all taken into account to determine how much you are able to borrow.