* PLEASE NOTE: Nothing in this opinion constitutes financial advice. You should always seek advice from a qualified financial advisor who will take into account your individual circumstances.*
THE FACTS IN THIS OPINION RELATE TO THE UK HOUSING MARKET BUT THE PRINCIPLES HOLD ELSEWHERE
A mortgage is probably the single largest financial commitment that any of us are likely to make. Yet, surprisingly, it is one which many enter without giving it the serious thought that it requires. For many, the decision to purchase a property is the part of the process that takes the most time and given the most thought. The mortgage is almost an after-thought which starts and ends with “how much will the bank let me borrow?”
How much the bank will let you borrow should, in my opinion, never be the first, and certainly not the last, question. The right question to ask is “how much can I afford to pay back each month?”
At the risk of teaching Grandma to suck eggs, a mortgage in layman’s terms (not legal terms!) is simply a loan secured against a property. You agree with the lender that you will repay the loan, together with interest over the course of (or at the end of) the term and, to ensure that you keep to your side of the bargain, the lender will take a mortgage over your property which it can enforce in the event that you do not make the right payments at the right time. Once you have repaid the loan (plus interest) the bank will release the mortgage over your property.
Given the fact that you stand to lose the roof from over your head if you don’t get it right, the question of affordability should be foremost in your mind. One way of working this out is to do a simple set of accounts. Write down on one side of a piece of paper all of the money you have coming in each month, be it salary, benefits or investment income. On the other side write down all of the amounts you have going out. These will include direct debits for things such as gas, electricity, council tax (this figure can be obtained from the council responsible for your new property or estimated) and TV licence, food bills, entertainment expenses and credit card bills. Don’t forget to include one off payments, such as the cost of insurance or holidays in your calculation by taking your annual spend and dividing it by 12 to get the monthly amount. Include too, any amounts which you would like to save each month. The value of savings should not be underestimated it might just provide the pot to get you out of trouble. Total up both columns and take your outgoings away from your income. This should hopefully give you the figure of how much spare money you have to spend on a mortgage. By way of example:
INCOME:
Salary: 1500
Benefit: 80
TOTAL 1580
OUTGOINGS
Telephone 20
Gas/Elec 40
Food 200
Entertainment 50
Insurance 10
Clothes 30
Savings 100
Misc 100
TOTAL 550
This scenario leaves a maximum of 1030 to play with for a mortgage repayment each month (NB these figures are inaccurate estimations of the expenses!). At an interest rate of 5.75% (and not taking into account any rate rises) this would mean you could afford to borrow around 160,000 over 25 years.
There’s an important assumption there though: the fact that it doesn’t take into account interest rate rises. If you really are putting ALL of your spare cash into a mortgage and the rates do rise you could find yourself unable to pay the loan. Similarly, if, for example, you are relying on two wages to pay the bills and one of you loses your job, where will you be? Can you afford to take a drop in salary and still make those mortgage payments? It can pay to be cautious. You never know when redundancy, illness or other life event might hit!
Having worked out what you can afford (rather than simply what the bank will let you borrow usually what you can afford will be less than the maximum a bank will lend) the next question to ask is what type of mortgage do you want.
The market is flooded with products but it can be simplified. At its most simple the loan you take out will be either a repayment or an interest only loan. The difference between the two is when you pay the actual loan amount back. With a repayment mortgage you will pay back a little of the loan each month so that the amount outstanding falls over the term. With an interest only mortgage you only pay the interest on the loan during the term and then pay the whole of the loan back at the end of the term. In order to do this you will need some kind of linked investment product that will help you to ensure that you have enough money at the end of the term to pay back the loan. Traditionally this investment product would be an endowment but now there are various other investment vehicles that are available including ISA and other tax efficient vehicles. Most people, however, will opt for (and probably benefit from) a repayment mortgage.
The choice is not over here though. You’ll then have to decide what kind of interest you’ll have to pay (and, unfortunately, the answer is never none!). There are a variety of products on the market from the simple variable rate mortgage through to a capped rate. Which you opt for will depend on your circumstances.
The headline rate for a variable rate mortgage will often (but not always) be the cheapest. The rate of interest you pay will vary over the term of the loan according to market conditions. If the Bank of England base rate rises you can be sure your mortgage rate will rise. If it falls then your rate should fall too, although don’t expect it to fall as quickly as it rose when the rates went up! With a variable rate mortgage you cannot be 100% sure on day one exactly how much your repayments will be at any given point during the term of the loan.
If it matters to you how much you pay then you may be able to opt for a fixed rate mortgage. Here the interest rate will be fixed for a period of time, generally between 2 and 5 years and so you’ll know exactly what you’ll be paying. The trade off here is often a lock-in for the period of the fixed rate meaning that if you want to change your mortgage during this period there will be a penalty of some kind. After the fixed rate period the mortgage will generally revert to a variable rate.
A halfway house between these two types of mortgages is the capped rate. Here you have a variable rate mortgage but a promise from the lender that the rate will never rise above a certain level. The rate will vary until the variable rate goes above your cap and then at that point the bank cannot charge you any more than the capped rate of interest. Again, the capped rate is likely to be for a 2 to 5 year period and there will be a lock in in most cases.
If money is tight to start with you might also be tempted by a discount rate mortgage. Here you have a variable rate product but the rate is discounted for the first few years. This can be useful but you are likely to have a lock in and may have to pay back the difference between what you paid under the capped scheme and what you would have paid with a normal variable rate product if you want to end the mortgage early.
Enough choices? Not quite.
Increasingly popular are what was known as “Australian style” mortgages when they hit the financial scene, but are probably better referred to as current account, flexible or off-set mortgages. These all vary enormously from provider to provider but essentially they allow you to use any savings you have to help pay off your mortgage without losing access to those savings. They may also allow you to overpay, underpay and even take a break from paying your mortgage. If you have ANY spare cash at the end of the month you can often save a small fortune with one of these mortgages, but again, personal circumstances vary. The way that most of these mortgages work is that you have two “pots” a loan and a savings pot. If you have 100k on loan and 10k in savings you agree not to earn any interest on your 10k savings but instead only pay interest on 90k of the loan. As interest is calculated daily this means that you really can use the concept to your advantage and every extra payment that is made has a real effect on the amount you will pay in interest on the loan and the length of time it will take to pay off the mortgage. Sites such as Virgin’s One Account will have calculator tools that demonstrate this much better than I could by just using words.
There’s an added incentive if you are a taxpayer too as you don’t pay tax on interest saved (just earned) in effect you save tax. You’d have to be earning upwards of about 9% on your savings as a higher rate taxpayer to earn more interest than the amount you save by paying less interest on the mortgage. It’s complicated maths, but it works.
There are plenty of other things to consider such as loan portability (whether you can simply transfer your mortgage if you move) but the above should have given you a taster for the kind of things you ought to be asking. In my opinion, when you’re talking about the roof over your head, it pays to be prudent. You have to take some risks in life but knowing how to minimise those risks can make the difference between that 4-bed house you always dreamed of and a life of worry and stress wondering how you are going to meet the next bill.
* PLEASE NOTE: Nothing in this opinion constitutes financial advice. You should always seek advice from a qualified financial advisor who will take into account your individual circumstances.*