A mortgage is a loan that is secured against a property. It is most often used to buy property or land, but you can also take out a mortgage against your property and use it for other purposes. Mortgages are therefore a form of secured loan, which means that the mortgage lender has a right over your property. They can exercise this right if you stop meeting the terms of the loan—for example, if you stop paying interest, or do not pay back the agreed amount each month.
We use mortgages because it is nearly impossible for most of us to pay outright for a property. We simply could not save up the money fast enough, especially with the speed at which property prices have increased over the last 10 to 20 years. They are therefore pretty much essential for most house buyers. However, it is important to understand the terms of the loan, to make sure that taking out a mortgage is the right option for you—and that you have chosen the right sort of mortgage.
How Do Mortgages Work?
On the face of it, mortgages are fairly simple.
When you buy a house, you put down a cash deposit. This is usually at least 5% to 10% of the value of the house. You therefore need to save for this deposit.
Your mortgage lender, often a bank or building society, then lends you the rest of the money required to buy the house. This means that having a larger deposit means that you have a smaller loan against your property.
In return for enabling you to buy a house, the mortgage provider puts a ‘lien’ on the property. This means that their interest in the property is formally recognised as part of the purchase. You could see this as the mortgage company being a part-owner of your house until you have paid off the loan and all the interest.
You agree to repay the loan, plus interest, over a period, usually 15 to 25 years.
If you then default on the loan (that is, you stop paying the interest or the loan repayments), then the mortgage company can repossess the house, or force you to sell it, so that the company can recover the value of the loan.
Some Mortgage Definitions
Interest. This is the money that you pay to a lender for borrowing. It is, effectively, the cost of borrowing money rather than having to use your own. There is more about how interest is calculated in our page on Understanding Interest.
Base rate. The rate at which the ‘lender of last resort’ or central bank lends to other banks. In the UK, the lender of last resort is the Bank of England, in the eurozone, it is the European Central Bank, and in the US, it is the Federal Reserve. The base rate is usually lower than other banks’ standard interest rate for loans.
Standard variable rate (SVR). The standard rate of interest for mortgages set by a lender. If you are not on any special type of mortgage (e.g. a tracker or a discount mortgage) you will be on the standard variable rate. The standard variable rate often follows the movements of the base rate, but is invariably higher. This is usually the highest rate of interest offered by the lender on a mortgage —but there is more flexibility about switching to another lender.
Assessing How Much Money to Borrow
The big question for many people is to know how much money you can borrow—and also how much you should borrow.
There are several aspects to consider. Lenders will usually look at the amount that you earn. You are unlikely to be able to borrow more than about four times your annual income before tax.
However, lenders also consider your monthly outgoings, to make sure that you will be able to afford the repayments on a mortgage. They also check whether you will still be able to afford the repayments if interest rates go up, or if something happens to change your situation (for example, you lose your job, or have a baby).
You should therefore consider all these issues before deciding on your budget for house-buying.
Mortgage affordability calculators
There are plenty of websites that can help you to calculate how much mortgage you can get, and also what you can afford. It is a good idea to use a few to give you an idea of what you might need to consider, and to help you set a budget.
This will also help you to gather all the necessary information before you need it for your mortgage lender.
Types of Mortgages
There are two main types of mortgages:
Repayment mortgages, where your monthly payments to the lender cover both the interest and the repayments on the loan. This means that over time, you start to own more and more of your house until you own it all once you make the final payment.
Interest-only mortgages, where your monthly payment only covers the interest on the loan. You have to repay the loan in full at the end of the term (that is, after 15 or 25 years), although you can pay it off before that if you wish to do so.
The payments that you make will be smaller with an interest-only mortgage, because you are not making any repayments. These mortgages can therefore look like a better deal. However, you need to make sure that you make provision to repay the mortgage at the end of the term, for example, through regular investments in a savings account or stocks and shares.
Within each type of mortgage, there are also different types of arrangements about exactly how your mortgage interest is calculated each month. These include:
Fixed rate mortgages, where the interest rate is fixed for a set period, such as two year, or five years. These deals are good if you have very little flexibility in your budget, and you need to know how much you will be paying each month. However, if the lender thinks that interest rates will rise, they will be more expensive than other types of mortgage.
Tracker mortgages, where the interest rate follows the central bank’s base rate of interest (see box above) for a set period. This means that your monthly payments can change—but they can go down as well as up. The good thing about tracker rates is that the central bank usually only changes interest rates when it is really necessary to control inflation, so the base rate is usually steadier than the standard variable rate. These are therefore a higher risk for you, but that can make them cheaper than fixed-rate mortgages.
Discount mortgages, where the interest rate is pinned at a certain percentage below your lender’s standard variable interest rate (see box above) for a set period. Like tracker mortgages, these can vary over time. The main difference between these and trackers is that the lender can change your payments at any time by varying their standard variable rate. With a tracker mortgage, only a central bank decision can change your payments.
Check the Small Print!
A few lenders, especially building societies and mutuals, may link their standard variable rate to the bank’s base rate to give borrowers more security and stability. This means that their discount mortgages are effectively tracker mortgages.
Offset mortgages, where the value of any savings that you hold in a linked bank account is taken off the value of your loan when calculating the interest. This means that you have the flexibility of still being able to access your savings should you need them, but you are paying less interest each month until you spend the money.
Not all these deals will be available to everyone.
For example, some deals—usually with a better rate of interest—are only available if you have a larger deposit. You may also find that you are limited by the type of property you are planning to buy (flat vs. house, for example). There may also be different deals available if you can afford to pay the mortgage off sooner—within 10 or 15 years rather than the standard 25 years. It is therefore worth shopping around to see what deals might be available to you from different lenders.
If in Doubt, Ask for Advice
There are advantages and disadvantages to all these types of arrangements.
If you are not sure which is best for you, it is a good idea to talk to a mortgage broker or financial adviser. They will also be able to advise you about issues like the arrangement fee, and ensure that you compare all possible deals on a like-for-like basis.
With all these types of arrangements, there may be a penalty if you switch your mortgage to another lender within the fixed term or set period. Once the set period is over, you will usually automatically be moved to your lender’s standard variable rate—at least, until you agree another fixed term arrangement, also known as remortgaging (see box).
Remortgaging is the process of agreeing a new mortgage deal. This may be either with your existing provider, or with an alternative provider.
Why would you remortgage? It gives you access to better deals than the lender’s standard variable rate.
It is therefore well worth the effort, and you should start to look at new deals when you are about two months away from your old deal ending.
It may be a good idea to use a comparison website to see what kind of deals are available, and ensure that you compare your current lender with other options.
For most people, mortgages are really the only way that buying property is affordable. However, you need to understand what you are doing—and particularly, the commitment that you make. If you cannot keep up the repayments, the lender can repossess your house, or force you to sell it to repay the loan.