What is a mortgage?

[edit] Introduction

A mortgage is a loan taken out to buy property or land. Most run for 25 years but the term can be shorter or longer.

The loan is ‘secured’ against the value of a home until it’s paid off. If the homeowner can’t keep up their repayments the lender can repossess (take back) the home and sell it so they get their money back.

Mortgages can be applied for directly from a bank or building society, choosing from their product range. Alternatively, a mortgage broker or independent financial adviser (IFA) can be used to give advice and compare different mortgages on the market, as well as mortgages which are not offered directly to customers. Some brokers look at mortgages from the ‘whole market’ while others look at products from a number of lenders.

It is sometimes possible to choose a mortgage without receiving advice – this is called an execution-only mortgage. Execution-only mortgages are offered under limited circumstances. Applicants are expected to know the following:

• Exactly what they want to buy.
• Interest rate and type.
• The length of the term.
• Mortgage type.
• How much they want to borrow.

Not all lenders will offer the execution-only option and mortgage brokers and financial advisers can’t deal on an execution-only basis. Regardless of an applicant going down the execution-only route, the lender will still carry out the same detailed affordability checks.

When buying a property, a deposit needs to be paid. This is an amount of money that goes towards the cost of the property being bought. The more deposit, the lower the interest rate could be.

Loan to Value (LTV) is the amount of a home that is owned outright, compared to the amount that is secured against a mortgage.

For example, with a £20,000 deposit on a £200,000 property, the deposit is 10% of the price of the property, and the LTV is the remaining 90%. The mortgage is secured against this 90% portion. The lower the LTV, the lower the interest rate is likely to be. This is because the lender takes less risk with a smaller loan. The cheapest rates are typically available for people with a 40% deposit.

[edit] How does a mortgage work?

The money borrowed is called the capital and the lender then charges interest on it till it is repaid. The type of mortgage available will depend on whether the applicant wants to repay interest only or interest and capital.

[edit] Repayment mortgage

With repayment mortgages the interest and part of the capital is paid off every month. At the end of the term, typically 25 years, it should have been all paid off.

[edit] Interest-only mortgage

With interest-only mortgages, only the interest on the loan is paid and nothing off the capital (the amount borrowed). These mortgages are becoming much harder to come by as lenders and regulators are worried about homeowners being left with a huge debt and no way of repaying it.

A separate plan is needed for how to repay the original loan at the end of the mortgage term.

[edit] Combination of repayment and interest-only mortgages

Lenders can combine both options, splitting the mortgage loan between a repayment and interest-only mortgage.

[edit] Different types of mortgage

Mortgages come with fixed or variable interest rates.

[edit] Fixed-rate mortgage

Repayments will be the same for a certain period of time - typically two to five years - regardless of what interest rates are doing in the wider market.

• Pros: Monthly payments stay the same offering peace of mind to applicants and helping with budgeting.
• Cons: Fixed rate deals are usually slightly higher than variable rate mortgages. If interest rates fall, applicants won’t benefit from the lower rates.

[edit] Variable rate mortgage

The rate paid could move up or down, in line with the Bank of England base rate. There are various types of variable rate mortgages.

[edit] Standard variable rate (SVR)

This is the normal interest rate a mortgage lender charges homebuyers and it will last as long as the mortgage or until another mortgage deal is taken out. Changes in the interest rate may occur after a rise or fall in the base rate set by the Bank of England.

• Pros: There is freedom in being able to overpay or leave at any time.
• Cons: The rate can be changed at any time during the loan.

[edit] Discount mortgages

This is a discount off the lender’s standard variable rate (SVR) and only applies for a certain length of time, typically two or three years. However, it pays to shop around as SVRs differ across lenders, so it shouldn’t be assumed that the bigger the discount, the lower the interest rate.

Example:

Two banks have discount rates. Bank A has a 2% discount off a SVR of 6% (so 4% is paid). Bank B has a 1.5% discount off a SVR of 5% (so 3.5% is paid).

Though the discount is larger for Bank A, Bank B will be the cheaper option.

• Pros: The rate starts off cheaper which will keep monthly repayments lower. If the lender cuts its SVR, less will be paid each month.
• Cons: It is less suitable in terms of budgeting, as the lender is free to raise its SVR at any time. If Bank of England base rates rise, the discount rate will probably increase too.

[edit] Tracker mortgages

Tracker mortgages move directly in line with another interest rate – normally the Bank of England’s base rate plus a few percent. So if the base rate goes up by 0.5%, the payment rate will go up by the same amount. Usually they have a short life, typically two to five years, though some lenders offer trackers which last for the life of a mortgage or until a switch to another deal.

• Pros: If the rate it is tracking falls, so will mortgage payments.
• Cons: If the rate it is tracking increases, so will mortgage payments. There may also be an early repayment charge if wanting to switch before the deal ends.

[edit] Capped rate mortgages

The rate moves in line normally with the lender’s SVR. But the cap means the rate can’t rise above a certain level.

• Pros: There is certainty in that the rate won’t rise above a certain level. But homebuyers should be sure they could afford repayments if it rose to the level of the cap. The rate will also fall if the SVR comes down.
• Cons: The rate is generally higher than other variable and fixed rates. The cap tends to be set quite high and the lender can change the rate at any time up to the level of the cap.

[edit] Offset mortgages

These work by linking a homebuyer’s savings and current account to their mortgage so that they only pay interest on the difference. The mortgage will still be repaid every month as usual, but the savings act as an over-payment which helps to clear the mortgage early.

This article was created by --Money_Advice_Service. It was originally published on the Money Advice Service website.

You can see the original article here.

[edit] Related articles on Designing Buildings Wiki

• Buy-to-let mortgage.
• Chartered Institute of Housing.
• Cohabiting - Who owns what?
• Collateral.
• Commonhold.
• Construction loan.
• Council of Mortgage Lenders.
• Freehold.
• Green mortgage.
• Ground rent.
• Help to buy.
• Housing Strategy for England.
• Housing tenure.
• How can I improve my kerb appeal?
• Leasehold.
• Legal indemnities for property.
• National House Building Council NHBC.
• Property chain.
• Property development finance.
• Property guardianship.
• Property market.
• Property ownership.
• Property rights.
• Remortgage.
• Rent.
• Right to buy.
• Right to rent.
• Shared equity / Partnership mortgage.
• Shared ownership.
• Social housing.

[edit] External references

• Money Advice Service - A beginner's guide
• Money Advice Service - Understanding different types of mortgage

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