Mortgages explained
Buying your own home is the most important purchase you'll probably ever make, so
your mortgage is likely to be not only your biggest household expense but the most
significant financial commitment of your lifetime. For this reason we've compiled
a short guide to explain how mortgages work, so you can make a more informed choice.
What is a mortgage?
In simple terms, a mortgage is a loan used to purchase property. Mortgages are available
from banks, building societies and specialist mortgage lenders.
If you already have a mortgage and want to change to another product or lender without
moving home, it is known as a 'remortgage'.
How do mortgages work?
When you take out a mortgage you have the option of two repayment methods - 'repayment'
(also known as 'capital and interest') and 'interest only'.
With a 'repayment mortgage' you make monthly payments for an agreed period (the term)
until you've repaid both the capital (the loan) and the interest. During the early years
of the mortgage, the bulk of your payments are used to repay the interest on the loan,
however as time passes your equity in the property will increase and you can be confident
that the full debt will be repaid at the end of the agreed term.
With an 'interest-only mortgage' you make monthly payments for an agreed period but they
are only used to repay the interest charged against the loan, and not the capital. This
means that the balance of the loan will stay the same rather than decrease; however,
with this type of mortgage there is a risk of negative equity because property prices
may fall in the future, with the potential for the mortgage debt to become greater than
the property's value.
If you do choose an interest-only mortgage then in order to repay the loan at the end of
the term you'll need to set up an alternative method of repayment, such as a savings
account or investment plan. It's important that payments into your savings or investment
plans are maintained otherwise you may have insufficient funds to clear the outstanding
mortgage debt when you reach the end of the term.
When you choose a mortgage there are other factors to be aware of too:
The 'loan-to-value' (LTV) ratio is the amount of the mortgage expressed as a percentage
of the property's value. The lower the LTV, the more equity there is in the property.
If you have a lower LTV (typically below 75%) you'll generally have a greater choice
of lenders and mortgage products. In the past, a number of lenders offered 100% or
100+% mortgage products, where the amount of the mortgage was equal to or greater than
the property's value, however due to current market conditions and falling house prices
these have all but died out. Where the LTV is high there is the risk of negative equity.
- Early redemption charge (ERC)
In the terms of some mortgages, for example fixed-rate and cashback mortgages, the lender
may apply an early redemption charge if the loan is paid off in part or in full within
a specified time period, including if you remortgage with another lender. Depending on
the term and size of the mortgage, the charge can be significant.
If the early redemption charge extends beyond the benefit or scheme period i.e. the period
during which a fixed, capped or discounted rate applies, then this is known as an 'overhang'.
With 'no overhang' products you only have to pay the early redemption charge if you redeem
the mortgage in part or in full during the benefit or scheme period.
Not all mortgages require a booking fee, but where they do, the fee is normally required to
be paid up front at the time of the mortgage application. You pay this fee to reserve
funds on a mortgage product that has limited availability, for example a fixed rate product;
often the fee will be non-refundable so if you cancel your application the fee will not
be reimbursed.
An arrangement fee is usually charged on completion of the mortgage and most lenders will
allow you to add it to the loan, however this means that it will accrue interest along with
the remainder of the outstanding balance.
- Mortgage indemnity premium
Also known as a 'higher lending charge', this is an insurance designed to protect your
mortgage lender in the event that your property is repossessed and sold at a loss. The
mortgage indemnity premium is designed to cover the lender for the short-fall between
the sale price and the outstanding loan amount but it provides you, the borrower, with
no protection at all. Usually, a mortgage indemnity premium is only payable where the
LTV exceeds 75% and some lenders now only apply it where the LTV exceeds 90%.
In the next part of our guide, we'll explain the different types of mortgages available.
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