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.
But how exactly to mortgages work, hat are the different options available and how do you get a mortgage? We explain all below…
Why you need a mortgage
Buying a house is more expensive than ever, so it is inevitable you will have to take out a large loan in order to pay for it. The average house price in the UK is now £218,000 – which is not far off ten times the average annual salary of £27,000 – so it’s fair to assume that buying a house outright with case is out of the question for most people.
That’s where mortgages come in, which for many people is the largest loan they will ever commit themselves to. A mortgage is a type of loan that you can take out via a bank or building society which can be used to pay for a house.
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 (typically between 5 – 20%). The mortgage will then take care of the rest of the value of the house, which you 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 you will own the house outright.
At the end of this period, you’ll own your home 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 – repayment v interest-only
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 these days, 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 (25, 30 or 35 years normally) 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 at the end of the specified mortgage term. The monthly repayments would be much cheaper, but these days it is very rare for mortgage providers to provide an interest-only mortgage.
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.
Different types of mortgage rates
When you start looking for mortgages, you are immediately inundated with different rate offers for Fixed, Tracker and Variable mortgages.
A fixed rate mortgage is one that, unsurprisingly, has a fixed rate of interest throughout the entire term. These are good if you link to know exactly how much you will be paying each month so you can budget accordingly.
Tracker mortgages are a form of variable rate which follow the Bank of England’s base rate of interest. As a general rule, tracker mortgages tend to have lower repayments than fixed rate ones – and with interest rates currently being low a tracker mortgage might look the most appealing. You need to be aware that this could change though, with any significant rise in the base rate leading to much higher mortgage payments.
It all basically depends on whether you prefer the stability that comes with a fixed rate mortgage, or want the flexibility of tracker mortgages.
Another form of variable rate mortgage is the Standard Variable Rate (SVR), which is usually what lenders will put you on after your initial rate deal has expired. 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).
What you need to get approved for a mortgage
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) 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.
How much can you 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.