There is often an assumption that everyone knows what a mortgage is. However, many first time homebuyers only have a very basic grasp of what a mortgage is and what role it plays in enabling them to buy a house. The objective of this article, therefore, is to provide a brief overview of what a mortgage is and the key features that homebuyers need to be aware of.
A mortgage is a type of loan:
Even if we haven’t taken out a bank loan, we’re all aware of the basic premise of lending people money. If you lend your friend money to buy a cinema ticket, then you expect them to pay you back at some point in the future. A loan is a formal agreement between you and your bank and the bank agrees to lend you a sum of money, with the proviso that you agree to repay the money within an agreed timeframe.
The lender doesn’t lend the money just out of the goodness of its heart, however. Instead, it expects you to pay back the loan amount (which is called the capital sum), plus pay interest on top of that. This is why paying for something with a loan is more expensive than paying with cash.
Whilst a mortgage is a type of loan, it is a little different from a car loan or a student loan. For starters, the sum of money involved will normally be far higher when you are buying a home. This makes it a higher risk for the bank if you take the money but then can’t afford to keep up on payments. To reduce this risk, mortgages are a secured loan and we’ll look at what that means next.
Mortgages are a secured loan:
Most of you will be aware that there is a risk of losing your home if you aren’t able to keep up on mortgage payments to your bank. The reason for this is that when the mortgage is agreed, you consent to the fact that the mortgage is secured on the property. This means that the lender is entitled to sell the property to recoup funds in the event that you aren’t able to repay the mortgage. This is why it’s essential that homebuyers are confident that they are taking on a debt level that they can comfortably afford to repay.
How a mortgage works:
There are two main considerations that homebuyers need to determine when taking out a mortgage. Firstly, what size of mortgage do you want and, secondly, over what period will you pay off the mortgage.
The size of mortgage will be determined by the price of the house that you wish to buy and by how much savings you have to put towards the purchase. One important thing to be aware of is that lenders almost always require an initial deposit, and this typically is 10% of the purchase price.
So let’s imagine that you wish to buy a house for £100,000. You would need to pay at least £10,000 upfront as a deposit (sometimes also called a down payment). You could then take the remaining £90,000 via the mortgage.
You should look to minimise the size of mortgage that you take out. Therefore, in the above example, if you happen to have £20,000 that you could comfortably put towards the purchase, then doing so (and taking out a smaller mortgage) would be financially prudent.
Mortgages are always agreed for a set period of time, and this is referred to by lenders as the “mortgage term”. Typically, mortgages are taken over quite long terms, such as 20 years or 25 years. However, the key thing to remember is that the faster you are able to pay off the mortgage, the less you will end up paying out in interest. You should work out how much you can comfortably afford to pay each month and then ask the lender to advise what term would apply if you make that level of monthly payment.
The payment of interest on mortgages:
It’s vital that you understand the role that interest plays when you take out a mortgage. Let’s go again with the example where you’ve taken out a mortgage for £100,000 and let’s say that you’ve agreed to pay back the mortgage within 25 years. A common mistake that first time buyers might make is to think that they just need to be able to pay £100,000 over that timeframe.
However, the reality is that you are not only going to have to pay back that initial “capital sum” but also the interest that is charged on a monthly basis on the mortgage. So if the mortgage interest rate was 5% and you had £90,000 left on the mortgage, then the monthly interest would be £375.
The most common type of mortgage is a “Capital and Interest Repayment mortgage”. With these, your monthly payments cover the monthly interest plus a portion of the capital sum.
Eligibility for a mortgage:
Even though mortgages are secured on the property, there is still an element of risk involved for the lender when they agree to provide a homebuyer with mortgage funds. For this reason, lenders will always conduct a credit score to determine whether they are willing to lend you the money.
This process is also used if you apply for a standard loan, a credit card, or an overdraft and involves the bank collecting certain details about your finances and entering them into a computer system that will either return an “Accept” or a “Decline” decision. If you’re unsure about this part of the process, then the best thing to do is to speak to the bank official who will be able to provide further guidance and information.
The mortgage drawdown process:
Once you’ve been approved for a mortgage, there’s a process that needs to be gone through before the mortgage account is opened and this is linked to the parallel process of buying your home.
On confirmation that the seller has accepted your property bid, your solicitor will need to liaise with your bank to complete the necessary paperwork to authorise the mortgage to be opened. You don’t need to know all the fine details of this process but you should make sure that both your bank and your solicitor are acting diligently and that they are keeping you informed of progress.
Making one-off payments into the mortgage or varying the monthly payments:
Once your mortgage is open, the agreed monthly payments will start to come out of your current/checking account automatically each month by direct debit. It’s usually sensible to arrange for the direct debit to be set up (by your bank) for the day after your pay day.
You could just sit back and allow the payments to come out of your bank account for the entire length of the mortgage and your main task would be to ensure that you don’t miss any payments due to lack of funds.
However, as already mentioned, the quicker you can repay the mortgage, the less money it will cost you over the entire mortgage term. For this reason, you may wish to look for opportunities to make additional payments into the mortgage. You will need to check with your lender whether they allow such payments.
Making additional payments is typically allowed where you have taken a mortgage that has a variable interest rate, and these type of mortgages are often referred to a flexible mortgages.
It is also possible to take out mortgages that have a fixed rate. For example, you may have opted for a mortgage where the interest rate is guaranteed to be 4% for the first 5 years, and will thereafter revert to a standard variable rate. Lenders tend to be more restrictive about allowing additional payments on fixed rate mortgages but will often allow you to pay up to 10% of the capital value. So if your mortgage balance is £50,000, then you may be able to pay in a lump sum of £5,000.
Taking out a mortgage can be scary and most first time buyers have limited knowledge of how mortgages work before they go through the process. However, there are plenty of good sources of information on mortgages and you shouldn’t feel afraid to ask family, friends, or your bank for explanations of how they work. It’s definitely worth taking the time to get the best mortgage for your circumstances and, hopefully, the end result will be you taking possession of the keys to your first home!