How do mortgages work? (A comprehensive guide)
- By: Ashley Saunders
- July 2018
The most common question asked by first time buyers is how do mortgages work? It might seem like the most naive question to wonder but it’s actually a good one.
After months of viewing, what feels like a hundred properties, you’ve found your dream home. You now turn your attention to mortgages. But with hundreds of products available, you’re left even more confuse about how you’ll purchase the home.
Don’t worry! Within this comprehensive guide, we’ll cover how do mortgages work, typical interest rates, if you need to pay fees to arrange a mortgage, and other common questions you might have.
What is a mortgage?
Let’s start with the most basic question: What is a mortgage? This is when you borrow a large sum of money to purchase a property.
As you can’t borrow 100% of the property’s price and so you’ll need a mortgage deposit, typically 20%. The other 80%, you borrow from the bank in the form of a mortgage.
Each month, you’ll pay a small fraction of the loan back. You’ll keep paying each month until 20 years later, you’ve paid the whole amount off. At this point, you actually own the property outright. Congrats!
The monthly amount you pay back depends on many factors including deposit size, mortgage term and your interest rate.
What you need upfront
If you’re planning to use a mortgage to finance your purchase, there’s a few things you need to check before you can apply. Firstly, make sure you’re on the electoral roll at your current address. This will take you a few minutes to sort.
Next, think about your credit score. If you’ve never had a credit card, then now is the time to get one. Use it in the same way as a debit card, just ensure you pay it off each month. This helps to build your credit score and will make you appear more creditworthy in the eyes of your potential lenders.
Lenders like to see your address history for the past three years – with no gaps. As well as payslips and bank statements from the past three months. Your last P60 or three years of accounts if you’re self-employed.
Also, if you have any loans or credit cards, then your lender will want to see statements for these as well.
It’s worth putting together a file with all of these piece of information as it will prove to any lender that you’re serious, prepared and have done your research. Also, having these important documents in one place can speed up the process.
Where to begin?
The best place to start is to research if there’s any incentives or government scheme available for your situation.
For example, the current Help To Buy scheme enables people with a 5% deposit to borrow 20% from the government. This means their total deposit is 25%. The remaining 75% can be borrowed from a bank.
Other government schemes include shared equity, where you purchase a part of the house using a mortgage and rent the rest. Another scheme is the first-time buyer’s ISA. The government will add up to £3,000 to any money you save into the scheme.
However, buying for the first time will incur a number of other expenses on top of costs. These could include buying new furniture, planning home improvements and sorting the garden out.
So, make sure to research schemes that help you achieve this goal, of owning a house.
How big a deposit do I need?
Since there’s no standard amount you will need to save for a deposit, it can be a tricky subject.
The basic principle is the larger the deposit, the cheaper the mortgage deals you will be able to get. This is due to the fact that you’re less risky as a customer if you’re putting up more money from the start and therefore have a higher chance of paying the lender back.
In recent years first-time buyers have typically used a 20% deposit to buy a house. While this sounds like a massive amount to save, remember there are many ways to raise a deposit including the government schemes already covered.
Many people rely on the “bank of Mum and Dad” for the deposit. This is known as a gifted deposit. It’s worth being careful with how you do this as the lender may require confirmation that the person gifting the money is aware that they will not have any claim on the property, and that they do not expect their money back.
While a majority of lenders are happy for family members to gift deposits, they may be more reluctant to lend if the gift has come from a friend.
If you have little savings or are unable to buy with a tradition mortgage, then you with the help of family or a friend can apply for a guarantor mortgage. Don’t worry we’ll get to what they are, shortly.
Since there are many ways to quickly build a deposit and a few options for how to boost yours, even with 5% of the property’s value, you should be able to get on the housing ladder.
A fixed rate mortgage means what you pay back each month doesn’t change throughout the loan term.
This type of mortgage is useful if you believe that interest rates may rise in the near future as you’re protected from any potential payment increases.
However, it’s worth realising that if interest rates fall, you could be paying more than you would with other mortgage types.
Lenders usually charge arrangement fees on fixed-rate mortgages. Also, you may be liable for an Early Repayment Charge, should you wish to pay the mortgage off before the end of the term.
A variable rate mortgage means what your monthly payment will change as the underlying interest rate rises or falls.
Some people prefer this mortgage type as they believe the will save money over the lifetime of the loan when compared to say a fixed rate.
However, as have had a decade of low-interest rates, it’s likely that in the next few years rates will rise and this could have a major impact on the amount you repay.
A Capped Rate mortgage is very similar to a fixed rate mortgage except that if the variable rate drops below the capped rate, the borrower will make payments based on the lower variable rate.
However, should rates increase, then the payments will be ‘capped’. Again, as with fixed rates, up-front charges and ‘lock-ins’ are common.
An Interest only mortgage you pay-off the interest on the loan but not the capital. At the end of the mortgage term, you are expected to repay the capital.
Interest-only mortgages have grown in popularity in recent years amongst buy-to-let investors and first-time buyers because they are cheaper than a repayment mortgage.
If you have no deposit or your financial circumstances would usually put lenders off, then Guarantor mortgages can help you buy a home.
Your guarantor will not own a share of the property you buy or be named on the title deeds. However, they have to sign a legal agreement to make your repayments for you if you fall behind.
The lender will also insist that they either have a charge over their home or require your guarantor to place a lump sum into a savings account with the lender, which can not be touched until certain conditions are met.
A family member or even friend can be your guarantor, but some lenders will restrict who you can choose.
Will I have to pay mortgage arrangement fees?
While there are many companies who offer no arrangement fees on mortgages, many mortgage brokers do charge. Along as you are confident that paying an arrangement fee is enabling you to get the best mortgage and have budgeted for this extra cost, then there’s no need to worry.
Lenders will often charge anything up to £2,000 to arrange your mortgage. Of course, if you haven’t thought about additional costs, then it may be best to talk to a professional advisor quickly so that these amounts can be worked into your budget.
Will the lender want to meet me?
Part of verifying any information you provide to the lender is for them to meet you in person for a mortgage interview. Typically, this take betweens 1 and 3 hours and is either conducted face-to-face or over the phone.
They will want you to answer a range of questions including some personal ones, so that they can build up a picture of your situation. You’ll walk away from the mortgage interview with a clearer idea of your finance better and what you can afford to borrow.
How do mortgages work when selling or moving house?
Jumping ahead a few years, when you come to move house, then you’ll have various different mortgage options available.
You can usually ‘port’ your current mortgage from one property to another. However, you will need to apply for your mortgage again. So you’ll need to satisfy your lender that monthly payments are still affordable.
If they’re happy to transfer your current deal over to your new property, then that’s good news. However, you may owe them fees for moving your mortgage.
If you’re upsizing then you could move your existing mortgage and try to borrow the additional funds from your lender. Please be aware that this new amount may be loaned at a different rate and conditions.
You could, however, remortgage your home with a different lender if your not subject to any early repayments or aren’t locked in.
Should there be a gap between the sale of your home and the purchase of your new property, then you can use a ‘bridging loan’. However, this type of loan should be your last resort as they usually very high-interest rates and fees.
Seek professional advice if you’re unsure. As you’ll be taking on addition risk as you’ll essentially own two properties for a period of time.
Understanding how do mortgages work
With a better knowledge of how do mortgages work, you can make a better decision when trying to buy your next home and be able to better compare different mortgage products.
Regardless of your situation, it’s worth seeking professional advice from either an IFA or mortgage broker and not solely relying on information from your bank.