For many, taking out a mortgage will be the most expensive purchase they ever make. This guide will explain the different aspects of what makes up a mortgage, as well as decoding some of the industry jargon.

What is a mortgage?

A mortgage is a secured loan to buy a property. These differ from unsecured loans, which you may take out to buy a car, for example. The loan’s ‘security’ is the home you intend to buy. This means that should you default on your mortgage repayments, you have agreed with the lender that they can take over ownership of your home. Using a property as security will lower your perceived ‘risk’ to a lender (in comparison to taking out an unsecured loan). This means that lenders can charge you a lower rate of interest than you would normally be charged for taking out an unsecured loan.

To find out more about mortgage repayment difficulties, read our Guide to Mortgage Arrears.

What is Loan to Value?

Before the financial crisis of 2007, it was possible to take out a mortgage loan for the total amount of the property’s value. This was known as a 100% Loan to Value (LTV) mortgage. However, after the crash, lenders tightened up their regulations. The maximum loan to value banks are permitted to lend now is around 95% LTV.

This means that if you want to buy a home that costs £100,000, you would need to have at least £5,000 of your own funds to secure a loan for the other £95,000. The higher the amount you’re borrowing, the more difficult the loan will be to secure. The rate of interest for a high LTV loan will also be higher. 

Check out our guide to applying for a mortgage to find out more about lending criteria.

A mortgage loan is made up of two parts;

• Capital – The bulk of the money you borrow to buy a property.
• Interest – This covers the provider’s costs of lending you the money and this will be charged as a percentage of the mortgage loan every year.

The payment of your mortgage loan can be done in two ways;

• Repayment Mortgage – This is where you pay back a certain amount of the mortgage capital every month, as well as a rate of interest on top, to complete the mortgage term with a fully paid-up property. Your monthly payment will be higher than an interest only mortgage; however, it is a less risky loan for the lender. The mortgage loan can be paid back at a rate that is fixed for a certain amount of time, or you can choose a variable interest rate.
• Interest Only Mortgage – This is where you make interest payments to your lender every month to cover their costs, and then you save your own money to pay back the capital of the loan at the end of your mortgage term. You can also choose to pay this at a fixed rate for a certain period or at a variable rate of interest. To secure this type of loan, you will need a credible ‘vehicle’ (plan) for making up the mortgage capital. You could do this using a good share portfolio, money from inherited properties, pension savings or any other substantial savings you may have.  These types of mortgages are often sought by people who need a certain amount of cashflow, especially at the beginning of their mortgage term.

Can you Combine Repayment and Interest Only on your Mortgage?

It is possible to get a mortgage which is half repayment, half interest only. These are not available from all lenders, but may be a good option for those who may be hard-pressed to afford a full repayment mortgage. You will need a credible repayment vehicle in order to pay off the mortgage in full at the end of the term.

Let’s Look at an Example:

Sam needs a £250,000 mortgage to buy a £300,000 home. He can only afford full repayment of £175,000 towards the mortgage. However, he has inherited his parent’s house, which is worth £175,000. For this reason, Sam can secure a half repayment, half interest only agreement to cover his £300,000 mortgage.

Which Mortgage Should I Choose?

• When looking up rates on mortgage comparison sites, you may see a low rate advertised (3%, for example). However, there may be a hefty arrangement fee charged on top, which could cost around £2,000 to complete.  When making your final decision, it is worth doing the maths to see if a loan with no arrangement fees and a slightly higher rate may end up being the better deal for you.
• Further, watch out for discounted mortgages, where a special introductory rate is charged to incentivise new borrowers. After the discount period is over, your mortgage rate could rise to your lender’s Standard Variable Rate, which may not be the best mortgage rate for your circumstances.
• Some mortgages may also charge penalties, if you wish to switch deals or lenders later.
• An independent broker can help you work out your mortgage affordability and options. They can help you navigate;
  • Interest rates
  • Methods of repayment
  • Borrowing periods
  • Mortgages for specific scenarios (e.g. Buy to Let)
  • Extra charges and arrangement fees
  • Early repayment charges and exit fees

What is an Early Repayment Charge?

These are also known as early redemption fees/penalties and are enforced when you choose to come out of a mortgage agreement early. These are charged at a percentage, based on the amount of loan still outstanding. Details of repayment charges will be made explicit when you apply for the mortgage (these will be outlined in a Key Facts Illustration document). Early repayment charges are made up of two parts;

• A set fee – this covers the admin costs and could be hundreds of pounds
• A few months’ interest – this varies but could be thousands of pounds.

Some tracker and standard variable rate mortgages have no early redemption penalties attached. You can find out what the possible charges may be from many early redemption calculators you can find online.

How Can I Exit my Mortgage?

You can exit a mortgage in two ways;

• Remortgaging – This is where you repay your existing mortgage in full and take out another mortgage product.
• Ownership – This is where you have paid off your mortgage entirely, so you own the property outright.

Main Mortgage Types

Fixed Rate Mortgages – Popular with first time home buyers. These freeze your interest and capital repayments to the same amount of money every month, for a fixed period. These fixed periods could last two years, three, five and sometimes ten years. The downsides to this type of mortgage is that should the Bank of England base rate of interest fall, those on fixed rate mortgages cannot lower their monthly repayments. On the plus side, if the base rate rises, those on fixed rate mortgages will be unaffected. It is worth noting that at the end of your fixed term, your rate may change to your lender’s standard variable rate. At this point it may be worth searching for another fixed rate deal or switching to another mortgage type.

Variable Rate Mortgages - All mortgage providers have a standard variable rate of interest (SVR). This interest rate is usually influenced by the BoE base interest rate with a certain percentage added on top of that. SVR rates tend to be higher than fixed rate mortgages. And it is also worth noting that if the Bank of England base rate lowers, it doesn’t automatically mean a lender’s SVR will also fall.

Tracker Mortgages – These mortgages are like SVR mortgages; however, tracker mortgages offer a smaller rate of interest charged on top of the Bank of England Base Rate. For instance, if the Bank of England Base Rate is 0.25% and the lenders add on 1.75% your mortgage interest rate would be 2%. These are great for people who are looking for a good deal on their mortgage, but can also afford to pay a higher amount every month, should the base rate increase.

Discount Rate Mortgages- These mortgages are often offered to incentivise new mortgage applicants. This is where your mortgage rate will be at a special discount for a fixed period, after which your monthly payments will increase. This discount usually falls in line with the lender’s SVR rate and you will typically be offered a discounted offer of two to five years. It is worth noting that if your mortgage is tied to a lender’s SVR rate, your mortgage payments can also increase during your discounted period.

Capped Rate Mortgages- This is a variable mortgage type; however, these have an agreed maximum rate of interest. This means that you may not be charged over a certain amount of interest for your mortgage. This is good for people who wish to benefit from falls in interest rates, but don’t want to be ‘caught out’ should the rate increase to a certain amount.

Cashback Mortgages- These mortgage deals are also offered to incentivise new borrowers. These mortgages offer you some money back for your custom. This could be a percentage of the mortgage value. These are great for people who need a lump sum of money for moving house. However, you may find better deals with overall lower rates of interest elsewhere.

Offset Mortgage – These mortgages are linked to a savings account with the lender. Instead of paying off a certain amount of mortgage capital every month, you put it into the savings account. You pay interest on the difference between what you have saved and the figure still outstanding on your mortgage. The higher the amount of money saved in your offset account, the lower your interest payments will be. Also, you can still access your savings (although doing so may increase your mortgage payments). These are good for self-employed people, or business owners who may pay a high rate of tax, or need access to funds to invest in their business. These mortgages also tend to be more expensive than other deals and to be accepted, you need a credible payment vehicle in order pay the mortgage in full at the end of the term.

95% LTV Mortgages – These are known as high LTV mortgages and are for people who have difficulty raising a higher deposit. These mortgages are charged at a higher rate of interest than most because they pose more risk to lenders. If house prices fall by a small percentage of around 6%, those on 95% LTV mortgages could risk falling into negative equity. Where you owe more on your mortgage than your house is worth.

Joint Mortgages- This is the types of mortgage you would take out with one person (or up to four people). Borrowing as a group gives people access to a bigger mortgage loan. Ownership of the loan is divided either equally or by the percentage of deposit each party contributed. However, all persons named on the loan are equally responsible for repayments.

Guarantor Mortgages – This is a mortgage where a friend or family member acts as a guarantor for the loan. These are great for first time buyers who need assistance in their first few years of home ownership. However, those who name themselves as guarantor will be liable should the borrower miss loan repayments.

Flexible Mortgages – This is a flexible arrangement between you and your lender, where you have the option to overpay on your mortgage, should you need to make lower payments or take a payment holiday later. You may need to have overpaid at some point before your lender will allow you to underpay. However, these plans give you some leeway, without incurring extra penalty charges. But it is worth noting that the general interest rate may be higher than with other mortgage deals on the market.

Buy to Let Mortgages – These are exclusively for those looking to invest in property. The amount you can borrow is dependent on how much you could realistically charge your tenants for rent. The rates of interest, as well as the fees charged, will typically be higher than a residential mortgage.

See our Guide to Buy to Let Mortgages for more on how this mortgage type works.

To compare mortgage options for you, get in touch with an independent mortgage broker. They can offer you a free, no-obligation quote.