Mortgage Finance

Mortgages are widely used throughout the UK, and as a highly popular form of finance are one of the loans most people are likely to take out in their lifetime

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There are few forms of finance that are more common than a mortgage. Nearly every property in the UK is finance by a mortgage provider in one form or another, be that through a Buy-to-Let mortgage, specialist high-value mortgage, a simple residential owner-occupier mortgage or a commercial mortgage. With mortgages being so widespread, and almost everyone encountering them at one point or another, it’s important to fully understand the ins and outs of this highly common form of finance.

In this article we’re going to examine the broad strokes and finer points of mortgages, and the ways in which they can be tailored to meet the need of specific individuals. Just as with any form of finance a mortgage is a significant financial commitment, and borrowers will need to repay not only the loan itself but also the interest attached to it. As a secured loan, the lender will be entitled to repossess and sell the property if the borrower fails to pay, so it’s vital that anyone considering a property purchase fully understands what the foundations of mortgage lending are. Buyers should consult a specialist financial property adviser before looking to take out a mortgage, and should thoroughly read their mortgage provider’s terms and conditions.

The Building Blocks of a Mortgage

For many people a mortgage is non-negotiable; there’s simply no way of purchasing a house without the aid of a bank, and as a result it’s not a question of “if” they get a mortgage, but of which mortgage they get. Before we start looking at different types of mortgage and the details of each specific format it’s important to outline the basic foundations of mortgages in general.

Security:

A mortgage is a secured loan, which means that the property it’s used to buy is the collateral for the loan. If the loan goes unpaid then the lender has the option to reclaim their losses through the sale of the property, whether the homeowner likes it or not. In reality, this is a fairly rare occurrence, and most banks are willing to work with borrowers to arrange a solution, but it’s important to bear in mind the consequences of failing to keep up with repayments.

Loan-to-Value:

It’s rare for a mortgage to be used to pay for the entire cost of a home. If the bank contributes 100% of the money, there is little security for the lender; the borrower has no stake in the property itself, and if they decide to leave the loan unpaid there’s not a lot the bank can do in response. Almost all mortgages require a deposit of at least 5%, which guarantees that the borrower is invested in retaining the property. The proportion of money provided by the lender as compared to that put up by the buyer is known as the “Loan to Value” or LTV, and is expressed as the percentage of the property’s purchase price that is contributed by the lender. For example, if a £200,000 property is bought with £180,000 of mortgage it is said to be a 90% LTV mortgage.

Deposit Size:

Understandably, banks wish to lend to people who are safe bets. As a general rule of thumb, the safer the lender sees a mortgage to be, the cheaper they’ll make it, and the best interest rates are available to those who can prove they’re a safe bet to lend to. The most effective way of reducing interest bills is to put up a large deposit; the more money you contribute to the property upfront the more reliable the bank will perceive you as.

This is why it’s so crucial for buyers to do everything they can to maximise their deposit, because although it’ll be tied up in equity it will significantly reduce the amount they pay in interest over the course of their mortgage. Knocking half a percent of interest off a £180,000 mortgage will save £900 per year, or £22,500 over the course of a 25-year mortgage - definitely worth doing, if at all possible. Generally speaking, buyers should do everything they can to put down a 10% deposit, as the interest rates and options available at this point are significantly better than with a 5% deposit.

Length of a Mortgage:

Generally speaking, borrowers will have some choice over how long they take out a mortgage for. A standard term is usually 25 years, but can be much shorter or longer in some cases. A longer mortgage reduces monthly costs because the total loan repayment is split up into more sections; £180,000 paid back in 300 payments (25 years) costs £600 per month, while a 30 year mortgage will cost £500 per month in 360 instalments.

There is a downside to a longer mortgage, however; because interest is charged each year, the longer a mortgage is held for the more it will cost in interest. An extra five years of payments might reduce the ongoing cost per month, but in the end it will cost significantly more than a shorter mortgage. Taking out a long mortgage is therefore a good way to minimise monthly outgoing, while a shorter mortgage is cheaper in the long run.

Amortization:

Finally, we must mention how the monthly cost of a mortgage is calculated. With a standard loan, interest would be paid on the total amount outstanding each month; if you’ve borrowed £1,000 at 5%, you’ll pay £50 per month in interest. Once you’ve repaid some of the capital and are only borrowing £500, you’ll then only pay £25 per month in interest.

However, this system doesn’t work very well for a mortgage. It would result in mortgages being much more expensive right at the start, and gradually becoming very cheap as the capital is repaid. Obviously this is contrary to the situations of most buyers, who will have little money at the start of their mortgage (because young earners typically earn less, and because they’ve thrown every penny into their deposit), and will gradually earn more over the course of their life.

To avoid this, banks average out the interest on the mortgage over the course of the entire term, so that monthly payments remain the same throughout (unless interest rates rise). Although the owner’s monthly payments remain the same, the money is used differently throughout the course of the mortgage. To begin with, almost the entire monthly bill goes towards paying off interest, not capital, but as the years go by the balance slowly switches so that the buyer is quickly paying off the capital on the mortgage.

This benefits both banks and buyers; buyers aren’t hit with exceptionally high interest rates when they first buy a property, and because this makes larger mortgages more affordable it’s easier for banks to find reliable customers.

Types of Mortgages:

There are as many forms of mortgages as there are types of buyer, and since every individual has different needs there is a remarkable amount of diversity in the mortgage market. There’s a mortgage type that meets every need, and though it can be bewildering at first it’s important to fully appreciate what the different types of finance can offer.

Fixed Rate:

This is the most straightforward form of mortgage, and is especially appealing to those who value reliability in their monthly payments. As the name suggests, this mortgage comes with a fixed rate of interest that remains the same from year to year, so that borrowers can always safely predict what their monthly outgoings are. This type of loan is particularly well-suited to first time buyers on a budget, who need to keep careful track of exactly how much they’re paying out each month.

Most fixed-rate mortgages are only fixed for a specific length of time, generally from 1-5 years. After this period the interest rate defaults to the standard variable rate of the mortgage provider, which can fluctuate according to the base rate.

Variable Rate:

This is the standard mortgage for most lenders, and comes with an interest rate that can be varied according to market conditions. This can benefit borrowers because it ensures that they’re always receiving a competitive interest rate; if rates go down across the market, they’re likely to also receive a lower interest rate, while those on a fixed-rate mortgage wouldn’t stand to benefit. However, because this rate can be raised or lowered at will it’s harder to predict what the annual mortgage bill is going to be, which makes it difficult for homeowners on a budget.

Tracker:

This type of mortgage shares DNA with the standard variable rate, but is tied directly to the Bank of England base rate. This is the interest which the Bank of England charges when it lends money to other banks, and is used as a yardstick for interest rates in general; because this mortgage’s rate directly follows the base rate, it means that mortgage costs will only change as the Bank of England alters it. This protects borrowers from price hikes by lenders, and ensures that they’re only ever paying a competitive rate.

As with a fixed-rate mortgage, tracker rates are usually only available for a certain period of time. The rate of a tracker is generally expressed as the amount of interest above the base rate that is charged, so a rate that follows the base rate plus 2 percent would be “BBR + 2%”.

Offset Mortgages:

This relatively new type of mortgage is well-suited to homeowners who value flexibility in their mortgage plans. It rewards buyers by offsetting their savings against the cost of their mortgage; if a family has £20,000 in savings and a £180,000 mortgage, they only pay interest on £160,000 of the mortgage. This reduces their monthly bills and can provide a healthy relief from expensive interest charges, but the real benefit is that they are still free to dip into their savings at any point. This enables borrowers to reduce the cost of their mortgage without sinking money into equity, and lets them keep money on hand to pay for repairs or holidays whenever necessary.

Refinancing a Mortgage:

It’s becoming easier and easier for consumers to switch their mortgages from one provider to another. Although switching a mortgage is unlikely to be quite as fast as switching bank or energy provider, the UK Government is trying to encourage borrowers to switch by streamlining the process, and there are strong incentives for doing so.

Firstly, as mentioned above, the first few years of a mortgage often have an attractive interest rate (either a fixed or tracker) which becomes a standard variable rate once the term expires. By switching to a new provider it’s possible for homeowners to take advantage of this limited period all over again, and as it becomes easier to switch from one lender to another there’s little reason not to do so.

As well as benefitting from a renewed fixed or tracker rate, homeowners also build up equity in their property while they pay off their mortgage. The more of the property they own the higher a deposit they have, which means that when it comes to remortgage they’re often able to secure a more favourable interest rate as well. As outlined above, building up equity through mortgage payments is a slow process (because most of the initial payments go towards paying off interest), so it may take a while to increase equity significantly.

When remortgaging it’s important to remember that you’re essentially repaying the first mortgage early, so if the borrower is liable for any early repayment charges (ERCs) then these will need to be paid. Generally, ERCs are only payable for a certain time, so it’s important for buyers to pick their time wisely when thinking about refinancing their mortgage.

Buy to Let Mortgages:

Mortgages which are designed for owner-occupied properties are distinct from those for landlord-owned properties, and the terms of each type of mortgage are highly restricted. When applying for a mortgage for a buy-to-let property there are certain differences between what an owner-occupier will be able to receive and what a landlord can expect.

Firstly, Buy-to-Let mortgages are almost invariably more expensive. Because letting is a business it’s not quite such a safe loan to approve as an owner-occupied property, and as a result interest rates are generally higher. In addition, BTL mortgages must usually be secured with a much larger down payment than a standard residential deposit, with many lenders only offering mortgages with a maximum LTV of 80% (though there are exceptions).

There are also numerous checks to be conducted on the property which are not part of a standard owner-occupier mortgage. The bank must be satisfied not only that the property has been accurately valued, but that the rental income will be sufficient to comfortably exceed the costs of the mortgage. Currently, a property must generate 125% of the mortgage costs in order to be approved, but this is set to increase in the next few years (some banks already look for 150%, rather than 125%).

Because of these stringent requirements, buy-to-let landlords must make sure that the property they’re intending to purchase is well worth the money. With mortgages costing more, and with taxation on rental income a potent factor, landlords have a lot to consider when arranging mortgage finance on their buy to let property.

Applying for a Mortgage:

Securing a mortgage is never quite as straightforward as it might seem at first. Generally speaking, it’s best to begin the groundwork for a mortgage 12 months in advance; though it doesn’t take this long to actually acquire a mortgage, it’s important to build up a decent credit history in the months leading up to an application.

In order to apply for a mortgage, the potential borrower must submit some personal details such as their household income, as well as details of the property they intend to purchase. This gives the lender enough information to give a basic yes or no answer; bear in mind that a yes at this point is by no means an offer, it’s simply an indication that they may be willing to lend.

From this point, the applicant will be invited to submit more detailed information on their personal circumstances, which the mortgage provider will use to create an “agreement in principle”. This agreement shows the bank’s willingness to lend “in principle”, but does not guarantee that they will actually give you the money - there’s no binding agreement, and they are still free to withdraw if they decide the deal is no longer for them. For this reason it can be worth securing more than one offer from different providers, so that if one gets cold feet it isn’t the end of the world.

With a greater understanding of what makes mortgages tick, it’s possible for buyers to achieve a much more favourable deal for themselves. With a little groundwork and some patience, any buyer can find a mortgage deal that works for them.

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