How mortgages work: a beginner’s guide
When you’re buying your first home, the unfamiliar world of mortgages is a steep learning curve. There’s a whole new language to get to grips with, a huge number of deals and lenders to choose from and important decisions to make involving eye-watering sums.
What is a mortgage?
A mortgage is a loan from a bank or building society for buying a property that you pay back over many years. Most mortgages last for 25 years, but can be shorter or longer.
The lender ‘secures’ the loan against your home until you’ve paid it back. This means if you can’t keep up your repayments, the lender can repossess your home to sell it and get their money back.
Why the size of your deposit matters
To get a mortgage, you usually need a minimum deposit of 5% of the value of the home. To get a favourable interest rate, you may need a deposit of more than 20%.
The golden rule is: the bigger the deposit, the better the rate, which means your monthly repayments will be lower. If you can find a way to increase your deposit, such as asking parents for help, you’ll pay far less interest.
In mortgage best-buy tables, you’ll see lenders use the term ‘LTV’. This indicates how much of a deposit you need to get a particular interest rate. LTV stands for the loan-to-value ratio, which is the percentage of the property’s value that you need to borrow.
For example, if you want to buy a £200,000 home and have £20,000 in your account that you can use as a deposit, you will need a mortgage of £180,000. As this is 90% of £200,000, your LTV would be 90%. If you’re buying a new-build home, look for a broker who specialises in new builds as some lenders may only lend you 85% of the value of a new-build house, or 75% on a new-build flat.
What are your repayment options?
A mortgage has two parts: the capital, which is the fixed amount you borrow; and the interest, which is the lender’s charge on the amount you owe. The first mortgage decision you need to make is how you want to repay the capital and the interest.
- Repayment mortgage: This is the most widely available repayment option. With a repayment mortgage, you make monthly repayments for an agreed period (known as the term) until you’ve paid back both the capital and the interest. As long as you keep up the repayments, your mortgage balance will get smaller each month and will be repaid by the end of the term.With this type of mortgage you repay more each month, but you’ll be chipping away at your debt so will owe nothing come the end of your mortgage term.
- Interest-only mortgage: This is where you only pay the interest on the loan each month and repay the full amount borrowed at the end of the mortgage. Lenders will want to see evidence of a separate savings plan for how you intend to repay the capital at the end of the term.
Fixed vs. variable-rate mortgages
Fixed vs. variable-rate mortgages
Once you’ve decided how you’re going to pay back the capital and interest, it’s time to think about what type of mortgage you want. There are many different kinds available but they broadly fall into two categories: either with fixed or variable interest rates.
With a fixed-rate mortgage, you have the certainty of knowing your repayments will be the same for a set period – typically two to five years. At the end of the fixed term, the interest rate reverts to your lender’s – usually higher – standard variable rate (SVR) or, depending on your circumstances, you can remortgage for a better deal. With a variable-rate mortgage, the rate you pay could change at any time, while tracker mortgages change along with the Bank of England base rate. Variable-rate mortgages are usually cheaper than fixed-rate mortgages, your repayments could go up at any time, so they’re not ideal if you’re on a tight budget.
To find out more about fixed-rate, variable-rate and tracker mortgages and their pros and cons, read our guide to understanding different types of mortgages.
How do you apply for a mortgage?
Applying for a mortgage is usually a two-stage process. The first stage involves the lender, mortgage broker or a New Homes Mortgage Adviser (NHMA) asking you a few questions to get an idea of what you can afford and what kind of mortgage you want. They’ll then give you a conditional offer (known as a mortgage agreement or decision in principle) which lets you know how much a lender might be prepared to lend you. This can be a handy thing to have when house-hunting as it shows you’re organised and ready to move quickly.
Once you’ve had an offer on a house accepted, the second stage is the full mortgage application where the lender conducts a detailed affordability check and asks for evidence of your income and deposit. If your application is accepted, the lender will provide you with a binding offer which is usually valid for six months, meaning you need to complete within that period.
If you’re buying a new-build home off-plan, timing can sometimes be an issue as your home might not be ready within six months. Some lenders do make mortgage offers for new-build homes that last for longer periods, so be sure to ask when you are applying.
Money Saving Expert’s Ultimate Mortgage Calculator will give you an indication of how much you could borrow as well as other fees and interest you need to pay.
This guide to mortgages was produced in collaboration with L&C Mortgages, the UK’s largest fee free mortgage broker and adviser.