Mortgages

Whether you’re about to start house-hunting, or planning your savings for the next 5-10+ years, it’s helpful to understand how mortgages work and how much you’re likely to be able to borrow, as this will determine your budget.

How mortgages work 🏠

When you take out a mortgage, you’re borrowing a set amount of money to use to buy a property, alongside your deposit. So for example, someone could buy a £200,000 house using a £180,000 mortgage and £20,000 deposit.

As you make payments on a mortgage, over time, the amount of money you owe decreases.

The balance of your loan is independent of the value of your property. It doesn’t go up if the value of your property goes up, and it doesn’t reduce if the value of your property goes down.

Mortgages are ‘secured’ borrowing 🔐

The most important thing to understand is that a mortgage is secured against a property. The mortgage company takes a legal charge against the property, that gives them the right to repossess and take ownership if the loan isn’t repaid.

This makes a mortgage the most serious borrowing most people will have in their lifetime, and it is incredibly important to keep up with repayments for this reason.

Missing payments on an unsecured personal loan may trash your credit record, but the same situation on a mortgage could result in being made homeless.

Interest and principal 📉

All mortgages involve paying interest on the money you’ve borrowed.

On a standard (‘repayment’) mortgage, in your payment each month you:

  1. Pay off the full amount of interest your debt has accrued that month, and
  2. Pay off some of the amount you owe (the principal).

For example if you borrow £150,000 at 2% interest, you would owe approximately £3,000 in interest in the first year, or £250 in interest per month, plus an amount of the capital.

How much of the principal you pay off each month depends on how long a loan you select. Payments on a 30 year loan will be much lower than on a 20 year one, as you have 10 extra years to pay off the same amount of capital. However the 20 year loan will be much cheaper overall, as you have 10 fewer years of interest payments.

Payments are calculated using a formula which balances interest and principal so that your payments stay consistent through the life of the loan. This means that the proportion of your payment going to principal increases over time, as each time you make a payment you owe slightly less in interest the following month. You can use this loan amortization calculator to view how this works.

Interest-only mortgages only require you to satisfy the interest payments over the term of the mortgage (in the example above, £250 per month), with the entire balance of the mortgage to pay when the term comes to an end.

Interest-only mortgages are popular with Buy-to-Let purchases, but are hard to obtain for normal residential borrowing. To qualify for an interest-only mortgage you must demonstrate that you will have the ability to pay back the entire capital at the end of the term (known as a repayment vehicle).

Loan-To-Value ratio (LTV)

Your LTV is a comparison between the value of your property and the size of your loan. For example, if your property is worth £200,000 and you owe £100,000 on the mortgage, that’s a 50% LTV. If you’ve just purchased a property with a 10% deposit, you have a 90% LTV.

The lower your LTV, the better the interest rates that will be available to you. So as you pay off your loan you will be able to access lower interest rates, and this will happen faster if the value of your home increases.

Home equity and negative equity

Your equity in your home is the value of the property minus how much you owe on your mortgage.

When you sell your property, the loan you owe is paid back first, and anything remaining is yours to put towards your next property or keep as savings. That’s your ‘equity’.

Home equity is not like cash in the bank – you can’t spend it at the shops. However, you can remortgage and borrow more money against your property, for example for major renovations or debt repayment.

Negative equity’ describes the situation where selling the property would not cover the loan. In this situation, to sell, you would have to use savings to pay the additional money owed to the lender.

Borrowing limits 💸

There are three main ceilings on how much you can borrow: your gross salary, your monthly affordability, and the percentage of equity required (loan-to-value).

Salary multiplier

The most you can generally borrow on a mortgage is 4.5 times your gross salary. So e.g. if you earn £25,000 per year, you would expect to be able to borrow up to £112,500.

If you’re buying with someone, you can use your joint gross income.

In some cases lenders will be able to lend more than 4.5x your salary, but the regulator requires this sort of lending to be less than 15% of loans granted, so it is an exception rather than the rule.

What counts as ‘salary’?

The rule of thumb is to assume that salary = guaranteed income. Lenders may additionally look at bonus, overtime, and so on, if there is good evidence of this occurring over time, but each lender will have a different policy.

For self-employed people or company owners, lenders will typically work on two or three years of past tax returns/company accounts. Lending multiples tend to be lower as self-employed earnings are generally considered higher risk.

Speak to a mortgage broker if your situation is at all unusual and you want to make the most of your income.

Affordability 🧮

As well as the maximum set by the salary multiplier, there is also a ceiling on how much you can borrow based on the affordability of the monthly payments.

For many people, this ceiling does not impact their maximum borrowing – the salary based limits are low enough that the payments are generally affordable.

However in some situations monthly affordability will be the lower ceiling, especially for those on lower salaries, or with high fixed expenses relative to their income (such as an expensive car payment), or with multiple dependants on a single income.

If you’re in your 40s or older you may also find that due to the shorter loan terms available you’re not able to borrow up to the full 4.5x your gross salary.

Note that a lender’s assessment of your affordability may not match your own budget. You might feel comfortable with £50 wiggle room after bills and necessities, but your mortgage lender will be more cautious, and take into account potential future interest rate rises or other eventualities.

LTV/Deposit

Lenders will have a minimum amount of equity required for you to take out a mortgage. Usually this is 5% or 10% of the value of the property.

For a first-time buyer, this means having the cash available as a deposit, and for a home-mover or remortgager this may be based on the equity in their current property.

So for example, if you had a £40,000 salary and could in theory borrow up to £180,000, that doesn’t mean you can buy a £180,000 property with no deposit. If the lender requires a 10% deposit you would need to put down at least £18,000 in savings and borrow the remaining £162,000.

To buy a property for £220,000 when your max borrowing is £180,000, you would need to have a deposit of £40,000 to reach the purchase price.

There are schemes available to help boost your deposit. Some examples are:

  • LISA: This savings account boosts first-time-buyer deposit savings by 25%, up to a total £1000 for every year of saving. The main limitations are that you must be a first-time-buyer and the house purchase price must be less than £450,000.
  • Help-to-buy equity loan: the government provides a loan of up to 20% of the property value, which is interest-free for 5 years. This is only available on new-builds and has many caveats.
  • Shared ownership: this involves part-buying and part-renting from a local authority or housing association.
  • Government 5% mortgage guarantee scheme: This is a scheme between the government and lenders, but should improve the availability of mortgages for people with 5% deposits.

Mortgage options

Mortgage term

As mentioned above, the shorter the term the less interest is paid overall, but the higher the monthly payments. Choosing a repayment term comes down to a combination of affordability and what else you would like to do with the money (for example, we have a page on overpaying your mortgage vs investing).

One popular strategy is to go for a longer term, and thus have lower minimum payments, but overpay from the outset, saving on interest as you would with a shorter term. This gives you flexibility to reduce payments if you run into hardship, but you may run into problems if you don’t have the financial discipline to stick to your overpayment plans.

Fixed and variable rate mortgages

Fixed rate

Most mortgages in the UK have a fixed interest rate for an initial set period. This period is typically 2 to 5 years, but other lengths of time are possible.

During this period your payments are a fixed, constant amount – they stay exactly the same every month.

After that period ends, if you didn’t arrange anything else, you would move on to the lender’s Standard Variable Rate. This would be a higher interest rate (and thus higher monthly payments), and the interest rate would also be subject to change without notice.

In practice, you arrange in advance for a new fixed rate deal to start when your current one ends, either with your current lender or a new one.

The main drawback of fixed rate is that they will include some form of ‘Early Repayment Charge’ – if you end the mortgage before the fixed term ends (for example by selling, moving house, or switching to a better deal), you will need to pay exit fees, which are often very significant. The same penalty can apply to overpaying your mortgage by more than a certain amount even if you are not paying it off fully.

Care needs to be taken if you are planning to overpay significant amounts or may repay early – you will generally want to wait until the fixed period is over before overpaying anything above the amount permitted without a fee.

Variable rate

There are a few alternatives to fixed rate mortgages, all of which involve some form of variable rate. The two most common examples are:

  • Tracker mortgage – typically tracks Bank of England base rate plus a certain percentage (i.e. BoE + 2%). These rates typically last the entire length of the mortgage
  • Discount mortgage – typically offers a fixed discount against the bank’s own Standard Variable Rate (i.e. SVR – 2%). If the bank’s rate changes, so does the repayment amount of your mortgage.

Choosing between the two

Usually variable mortgages offer lower interest rates than fixed rates, but fixed rates are generally more popular. By taking a fixed rate, you tend to pay a slight premium to guarantee that your budget will remain the same for the fixed period.

You may be tempted to ask if you should factor in the possibility of interest rates rising or falling in future, but this is generally a red herring, for the same reasons as mentioned in the market timing article. It makes much more sense to focus on factors you can control (which is better for my budget? should I take a lower rate but lose certainty? am I likely to move house in the next 5 years?), than unanswerable questions outside of your control.

Interest rate

As a rule, the lower the interest rate the better, but you should consider the effective interest rate over the relevant period with any fees included.

When you look at paperwork provided by potential lenders you will see some calculations of total cost of the mortgage, for the entire term. This isn’t helpful for a fixed rate mortgage as you shouldn’t be staying on the Standard Variable Rate, and if you did, by the time you got there it would be a different rate than the one quoted today.

A better approach is to look at the total cost (including fees) over the fixed or discounted period.

Fees

Mortgages usually cost a fee to arrange. This can be paid upfront, or added on to the mortgage balance (in which case you will pay interest on it for the length of the loan).

Some mortgage deals have no fee. They typically have higher interest rates to compensate for this.

It’s worth taking the time to calculate which combination of fees + interest rate works out cheapest.

When comparing, for example, a 2 year and a 5 year fix, consider that you would need to pay 3x the mortgage fees over the same period of time, if taking 2 year fixes.

Comparing mortgage deals

There are online tools which will do a quick comparison for you.

https://www.moneysavingexpert.com/mortgages/compare-mortgage-rates/

Note that these calculators generally focus on which deal costs you the least in total over the fixed period. However, it’s often preferable to calculate which deal costs you least in fees and interest over the fixed period. You might not mind paying a little bit more in total if more of your payment goes towards the principal and thus improves your long term financial position.

There don’t seem to be online calculators available for this, so you’ll have to do it by hand using a loan amortization calculator and/or spreadsheet. Or ask your broker.

Mortgage brokers / advisors

Mortgage brokers can be free to use or they might charge a small fee. Even if they do, this fee is usually payable when they arrange a mortgage deal for you – you should be able to speak to them for free to assess whether you want to work together and maybe get some quick advice.

Whether or not you pay your broker a fee, the majority of their payment will be from the lender they arrange a mortgage with. These are known as proposal fees and should be disclosed to you by the broker.

If you know people who have bought recently, ask for personal recommendations – you can also try local sites and noticeboards.

Look for a ‘whole of market’ broker. It is generally sensible not to use the broker recommended by an estate agent, because these tend not to be so impartial.

The mortgage application and home buying process

There is a fantastic mortgage guide for first-time buyers that includes other costs and considerations such as legal fees moving fees, and so on, found at Money Saving Expert:

https://www.moneysavingexpert.com/mortgages/mortgage-guide/