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What's a Mortgage?
A mortgage is a loan 'secured' against the value of that home. This means you could lose your home if you don't keep up the mortgage payments.
This section looks at taking out a mortgage to help you buy your home. (You can also use mortgages to pay for home improvements or to cover many other sorts of spending.)
There are basically two types of mortgage:
Repayment Mortgages (Capital and Interest):
1) You borrow for a fixed period of time - say 25 years - called the 'mortgage term'.
2) Your monthly payments go towards both repaying the capital and paying interest on the loan.
3) As long as you keep up the payments, the whole loan will be paid off at the end of the term.
Some repayment mortgages are flexible mortgages. With these, you choose how fast to pay off your mortgage, rather than aiming for a fixed term. You can pay off extra either monthly or through additional lump sums and, with some, you can reduce or even skip some monthly payments.
Interest Only (Endowment, ISA, PEP and Pension):
1) You borrow for a fixed period of time - the mortgage term.
2) Your monthly payments cover only the interest on the loan.
3) At the end of the term, you pay off the capital in one lump sum.
It is your responsibility to build up savings so you have the money you need to repay the capital (the amount you borrowed) at the end of the term.
You can do this in several different ways:
Endowment Mortgages:
An endowment mortgage combines an interest-only mortgage with an endowment policy which includes life insurance cover.
The endowment policy itself is not a mortgage - it is a long term investment.
As well as paying interest on the mortgage/loan, you make regular payments to the endowment policy.
The aim is to build up a fund by the end of the mortgage term which matches the loan you must then pay off.
The amount you save each month is set at a level which makes this goal possible, provided your investment grows at an assumed rate.
The actual growth of the investment is linked to stock market performance and may be more or less than the assumed rate.
Do not choose an endowment mortgage if you are uncomfortable with this investment risk since it is not guaranteed to repay the loan on maturity. The value of investments may fall as well as rise and the should the policy be cancelled in the early years you may receive back less than your original investment.
ISA, PEP and Pension Mortgages:
These are like endowment mortgages, except that instead of combining a mortgage with an endowment policy, you choose a different type of investment to pay off the mortgage loan at the end of the term.
The return on the investment is typically linked to stock market performance. There is no certainty that it will grow enough to pay off the mortgage in full. So, these types of mortgage are not suitable if you are uncomfortable with investment risk.
Currently, you save through either an ISA or a personal pension (which could be a stakeholder pension scheme).
There are different types of ISA. For mortgage purposes, you are most likely to use a stocks and shares ISA investing in, for example, unit trusts. It must be noted that the value of investments such as these may fall as well as rise and should the policy be cancelled in the early years you may receive back less than your original investment
In the past, you may have saved through PEPs (personal equity plans). From 6 April 1999, you have not been able to pay any new money into PEPs but you can keep going any PEPs you had already started before that date. From 6 April 1999, you should have switched your new savings to ISAs instead.
If you choose an ISA or a personal pension to pay off the mortgage loan, you may need to take out separate life insurance cover if you have dependants, however there are certain ISA's available for mortgage repayment purposes which do include life cover.
The Pension mortgage aims to repay the loan out of the tax free cash which is available at retirement.
How much can I borrow?
Usually, you can borrow so many times your annual income and that of anyone else you are buying the property with - for example, three times your income plus one times your partner's income or two-and-a-half times your joint incomes. However, these are usually the maximum amounts you can borrow - many lenders now take into account your fixed financial commitments when deciding how much to lend you.
Some lenders will advance the full value of the property - and might even pay your survey and legal expenses too. But there may be extra charges if you borrow more than a certain proportion of the property's value - say, 90%. With other lenders, you must put down a deposit - say 10% of the property's value.
Don't just borrow the maximum on offer. Check how much you can afford to pay given your other commitments. Make an allowance in case the cost of your mortgage goes up if interest rates rise.
How long should I borrow for?
The number of years you take out your loan for is called the 'mortgage term'.
Traditionally, most people have opted for a 25-year term. But you can always choose a shorter term than this and your lender might agree to a longer term.
The shorter the term, the less you'll pay in total for your mortgage. But, if you have a repayment mortgage, your monthly payments will be bigger.
Rising house prices have made it difficult particularly for first-time buyers to afford homes in some parts of the country. As a result, some advisers have suggested you should consider a mortgage term up to 50 years. A long term reduces your monthly payments but increases considerably the amount you'll pay in total. Bear in mind too that, if you are looking at a very long term because you would otherwise struggle to meet the repayments, you might also be storing up payment problems if, say, interest rates rise in future. And be wary of taking out a mortgage whose term extends beyond your retirement age - would you be able to afford the payments once your earnings stopped?
If you have an interest-only mortgage, you'll usually have to save more each month so that you build up the lump sum to repay the loan more quickly.
Do not choose a term which extends beyond the date you intend to retire unless you are absolutely sure that you'll have enough income in retirement to carry on meeting your mortgage payments.
Whatever term you choose at the outset, you can pay off your mortgage early - but check whether there will be extra charges if you do this.
What about different types of interest rates?
Variable rate - the interest rate on your loan may be varied (up or down) by the lender (often, but not always, as the Bank of England base rate varies).
Base rate tracker - the interest rate varies (up or down) directly in line with the Bank of England base rate.
Fixed rate - the interest is guaranteed to stay at a set level for a set period, regardless of any changes in the base rate.
Capped rate - the interest varies but doesn't go any higher than a set level even if the base rate does go higher.
Discounted rate - the interest can be fixed or variable, but for a set period you pay at lower-than-usual rate of interest; for example, a discount of 1% lower than the lender's variable rate for a period of say two years.
Deferred - the interest can be variable or fixed, but for a set period you pay at a lower-than-usual rate. BUT what you save is added to the amount of your loan, so you pay extra in the long run.
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