A Simple Guide to Mortgages
A simple mortgage guide.
Mortgages are a complicated beast. At least that’s what it often seems. There are so many options, literally tens of thousands that you can choose from. The vast majority won’t be right for you, and most you don’t need to know about. But of the remaining few hundred that might work for you, how do you pick the most appropriate one?
Well, this mortgage guide is going to try and educate you on the options available, what you need to do to get one and why getting the biggest mortgage possible might not be the best thing in the world.
What are they?
How do they work?
A mortgage is just like a giant loan. The only difference is the debt is secured against the property. So if you stop paying your mortgage, someone eventually comes and takes it off you. Doh!
Mortgages have been around for hundreds of years and came about due to the high cost of housing relative to the amount of money people had available. Sound familiar?
Generally you’ll get a mortgage for 25 – 35 years, and while you do have the option to only pay the interest off, most of the time on a residential mortgage you’ll clear the debt by the time the mortgage term expires.
But you don’t want to get 1 mortgage and then never think about it ever again for 25 years. That’ll cost you. We’ll look at why that is in this mortgage guide.
What are they good for?
Unsurprisingly, buying a home! Allowing you to buy something that you don’t have all of the cash saved up for, and giving you access to a nicer place / house than you could afford without one.
When mortgages go bad!
The problem with mortgages is when you take out one too big – either for the property or for the borrower.
If you stop paying your mortgage, then things get messy quickly. If you end up with a mortgage bigger than the property you own, things get depressing quickly!
There are ways to minimise this risk, but ultimately it is on you to not be too greedy when it comes to your spending habits.
What you need to know before you sign up for one
The most important things to know are usually provided to you in a pretty easy to understand document known as a KFI (Key Facts Illustration) or a ESIS (European Standardised Information Sheet).
This will let you know;
- What you’re borrowing
- How long you’re borrowing it for
- How much you’ll pay for it initially, both up front and per month
- How much you’ll pay for it after the deal (if there is one) expires
- How much you’ll pay in fees if you pay it all off early
- How much the mortgage company will pay your mortgage advisor
- What the total amount you will pay over the entire term of the mortgage
- And other useful things
The critical ones are how much you’re borrowing, what you’ll be paying, how long you’ll be tied into the deal.
The rest is important, but with these pieces of information you can assess the long-term impact it will have on your finances.
How do I use mortgages?
This is when you pay back the interest you owe every month, but don’t repay the amount of money you were originally given. At the end of the term, they come back and ask for a big ole sack of cash.
Let’s say you borrow £150,000 at 5% interest. You’d pay £625 per month. You’d pay that for 25 years (doubt it, but stick with me for the example here). Then you’d be asked by the lender to give them a final payment of £150,625 on the last month.
Now this is fine if you plan to sell the property in 25 years’ time. But don’t forget you’ll need somewhere to live.
This is often a preferred mortgage type for investors who can sell the property after 25 years and not become homeless.
The logic is that £150,000 right now is a lot of money, but in 25 years’ time, it’s not as much. Remember those £0.30 cans of Coke you could buy that now cost £1? That’s inflation working!
The alternative solution is to pay back the interest, but also a small part of the original sum that you borrowed each month.
So in the above example you’d pay back £877 per month, but after 25 years you’re free and clear.
Here’s a handy chart to illustrate the two options.
|Interest Only||Capital Repayment|
|Term||25 years||25 years|
|Balance outstanding after 25 years||£150,000||£0|
|Total paid back||£337,500||£263,000|
So while it might seem nice to have a lower payment each month at first, in the long run you’re much better off financially paying your mortgage down over time.
Loan to Value and how that works
Loan to Value, or LTV as it’s often called, is just what percentage the loan is versus the property price. So if you have a £100,000 house and want a £50,000 mortgage, that’s 50% LTV. If you wanted £95,000 mortgage, then it’d be 95%.
Pretty straight forward eh?
Now, lenders aren’t daft, so they know the more they lend the more risk they are taking on. So generally speaking, and this is just a guide, but the best mortgage rates will be up to 60% LTV.
The next step up will be at 70% LTV
Then again at 75%
Then a jump at 85%
Then finally at 95%
As the lender takes on more and more risk, they want to charge more and more interest to protect themselves.
Hopefully you can see that by the mortgage lenders calculations, it’s very unlikely that house prices will ever drop by more than 40%. Pretty unlikely they’ll drop by 25%, but then the odds of house prices falling by up to this amount goes up quite quickly.
It’s a fine balance between getting a good rate and getting as much money as you need to buy the house you want. But a good mortgage advisor will help you make that decision.
Fixed rate deals
When you think about it, the mortgage industry is pretty simple. A fixed rate deal? Well by golly that’d be a deal that has its rate fixed.
A ‘deal’ in mortgage terms is the length of time that you have some kind of introductory offer or initial term.
It could be as short as 1 year or as long as 10 years, but it is NOT the full term of the mortgage, which is more likely to be 25-40 years.
A fixed rate deal is simply a rate of interest that will not change for the length of the deal, no matter what happens with interest rates.
If you fix at 5% and the interest rates in the UK go up to 15%, then you still only pay 5%. Equally if the interest rates in the UK go down to 1%, you still have to pay 5%.
Variable rate deals
A variable rate deal is the opposite of the above and is linked to the Bank Base Rate of interest. This is set by the UK Government to control the economy (but that’s a whole other article on its own). A variable rate deal will go up and down depending on what the UK Government decides.
But when you sign up for the mortgage you will know exactly how your interest rate is linked. So, you might pay 1.5% +BBR.
This means if BBR is 4%, you’d pay 1.5% + 4% = 5.5% interest.
If BBR was 0.25%, then you’d pay 1.5% + 0.25% = 1.75% interest.
This is a great thing to have when interest rates are remaining static or going down but can be very painful if interest rates go up!
If BBR goes to 8%, then you end up paying 1.5% + 8% = 9.5% interest.
A good mortgage broker can explain the difference between the two types of mortgage. A great mortgage broker can explain where we are in the economic cycle and what the likelihood of future interest rate movements are going to be so you can protect yourself.
These are quite niche but work in exactly the same way as a Variable rate deal, however instead of being linked with the Bank Base Rate, they are linked to LIBOR or the London Inter Bank Offer Rate. This is the rate of interest banks charge each other to borrow money.
What do I need to qualify for a mortgage?
It helps to have a job, so you need to be earning money in some way to qualify for a mortgage. Whether that’s as a self-employed person, a company director, or an employee of someone else. Some means of bringing in money each month in order to pay for the mortgage will be a requirement.
Live somewhere traceable
Lenders are keen to know who you are and where you’ve been. So being able to trace your whereabouts for the last 3 years is generally a requirement. Doesn’t matter if it’s rented, at your parents, your own home, student accommodation. What matters if you have a clear history that they can follow.
What they are trying to avoid is you living in 4 different places and having credit cards and debts in loads of places to try and hide the amount of debt you’re in.
Have some kind of credit history
This could be a bank account, credit card, loan, anything really. Just a financial instrument to prove you can qualify for it in the first place, and then be responsible enough to manage it properly over time.
It’s the equivalent of letting someone ride a racing thoroughbred when they’ve never even sat on a donkey on the beach. You need to prove you know what you’re doing before you’re let loose on something much bigger and potentially more dangerous!
How is affordability assessed?
Affordability criteria is different for most of the lenders out there. But the basic premise is that they want you to be able to afford the lifestyle you have now, and still pay their mortgage. Some lenders calculate this as disposable income at the end of the month. Others use more standardised tests of each person costs £X per month.
It’s a unique calculation, which is why going to your bank and asking for money – while it seems the easy option, might end up costing you tens of thousands of pounds worth of money that you can borrow.
Earn a lot
The more you earn, the more you can borrow. Makes sense.
The more you don’t spend though, the more you can borrow as well.
If one client earns £40,000 and spends £25,000, then they will get a decent sized mortgage.
If another client earns £140,000 and spends £135,000, then they might not qualify for the mortgage that someone on £100,000 a year can get.
Now this is far too simple to be accurate, but it illustrates a point. A lender wants you to be in control of your spending, so while earning a lot will generally help you get a larger mortgage, not spending it all frivolously will also help!
Don’t have too much bad debt
Another thing all lenders will look at is the type of debt you currently have. If you have a lot of pay day loans, credit cards that are near maxed out, and car payments that are high. It starts to paint a picture of someone who can’t handle their finances.
Could well be a valid reason why you needed a payday loan. Maybe one you can talk your way out of. But if you’ve had a few of them, then you aren’t living within your means.
So, if you can, try to minimise the amount of debt you owe. Ideally paying your credit card bill off in full each month and keeping the amount you owe significantly lower than the maximum credit limit you have.
Might seem obvious, but it’s still worth saying. You should make sure you actually pay your debts. This probably isn’t something that needs drilling into you, but what may catch you off guard is random debts you’d forgotten about and that have somehow creeped up on you.
Often these are things like mobile phone tariffs or broadband charges that you thought you’d closed off but forgot the last months payment.
An easy way to check this is to review your credit file to see what outstanding debts you have and to keep an eye on any that might start showing as being in debt.
If you have had more serious financial issues, that’s not to say you won’t qualify for a mortgage… just that it’ll be harder and the lenders willing to take a chance on you are fewer.
Don’t avoid tax if you’re self employed
For the self-employed, it’s generally the goal to pay as little tax as possible (legally of course), so you can maximise the benefit you get from the company.
HOWEVER, this can backfire when it comes time to get a mortgage. As a company owner, the lenders will assess what you take home as well as the profits the company has made. If you’ve been keeping these as low as possible to avoid tax, then it starts to look like you don’t earn that much money.
This is going to limit the amount of money you can borrow because they don’t think you can afford much.
Now this is something to consider quite some time out from buying a property. Like 2 years out. While most lenders will ask for up to 3 years’ worth of accounts, a lot of them will only go off the last 2 years accounts when it comes to assessing your income. By making sure this is maximised, while it will suck that you pay more tax, will mean that you maximise your borrowing potential.
Why the mortgage companies are protecting you from yourself
It’s not for your best interest, it’s definitely for theirs. BUT the side effect of this is they are protecting you from yourself.
Most of us are daft enough to take out a £4m mortgage if it meant we could buy a giant castle. But we’d not really put too much thought into paying for it.
By ensuring that you can genuinely afford the mortgage payments each month, the mortgage companies are helping you stay solvent and avoid getting into financial trouble.
So, don’t feel bad if you can’t borrow as much as you wanted to. Instead take control of either your incomings or outgoings and improve the situation so you can prove you can afford more!
Mortgage Guide Conclusion
Mortgages can be amazing tools to buy something expensive, but they can also be a nightmare.
It’s critical to know what you’re letting yourself in for when you take out a mortgage. This is where a good mortgage advisor can be worth their weight in gold. You should be comfortable asking them anything, and they shouldn’t mind how many times they need to explain things until you 100% understand what you’re signing up for.
Hopefully this quick guide helps answer any initial questions you might have had, but for anything more specific then I’d be more than happy to have a chat with you to talk about your specific circumstances.
We’re all unique and delicate snowflakes, so each person will be different in what they need. That’s where I come in!
I want to make sure you know what you’re getting into, and can afford what you’re signing up for, and you end up with an affordable home and not with a huge debt around your neck!
Want more mortgage advice? Get in touch!