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A guide to how mortgages work

Stephen Lye

Written by

Stephen Lye

8 min read

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When you buy a property, you fund it in two ways: partly via a deposit that you save in advance and partly through a mortgage, which you borrow. If you are able to save 5% of the property value, you will need to borrow 95% of its value as a mortgage. If you save 15%, you would only need to borrow 85% of its value. The more deposit you save, the less you need to borrow.

A mortgage, therefore, is a large loan from a bank, building society, or other specialist lender that allows you to buy a property. The lender will charge you interest on the money you borrow. If you don’t keep up with your mortgage repayments, they have the right to take back the property.

Different types of mortgages

There are several different ways to repay a mortgage but typically, no matter which method you choose, the repayments are made on a monthly basis.

The first and most popular way is called a ‘repayment’ mortgage, also known as ‘capital and interest’.

With a repayment mortgage, part of your monthly instalments go towards reducing the capital – the amount you borrowed in the first place. And part of these payments are put towards paying off the interest you owe on that debt. The amount you owe each month will be determined by the amount you first borrowed, your interest rate, and how long the ‘term’ of your mortgage is. The term is the length of time over which you agree to repay your mortgage.

As you make payments over the agreed term of your repayment mortgage, the balance is steadily reduced. The balance will be repaid in full by the end of the term, meaning you will own your property outright.

A second type of mortgage is known as interest-only. As the name suggests, the monthly mortgage payments are made up of just the interest that is owed without reducing the capital. The capital will need to be repaid in full at the end of the mortgage term. Most lenders will need to know how you intend to repay this capital element before agreeing to lend you the money on an interest-only basis. This could include using money from your ISAs, pensions, investment bonds, regular savings plans or downsizing at a later date.

There is a third ‘part and part’ option which is a hybrid of the two types above. This allows you to pay a portion, rather than the whole, of the capital back. This reduces the outstanding amount at the end of the term.

How mortgage interest works

Interest is calculated on mortgages depending on the rate that you are offered by the lender. There are several different types of rates that are available:

Fixed rate – this rate will stay the same over the duration of your deal. A deal tends to last 2, 3, or 5 years but some lenders do offer up to 10 and beyond. The ‘deal’ period is relatively short and should not be confused with the ‘term’ (the length of time it will take you to pay off your entire mortgage.) Fixed rate deals are often popular as they help people plan their finances, knowing that their mortgage repayment will be a set amount each month. For this reason , they are popular with first time buyers.

Before we look at discounted and tracker rates, you need to understand what a Standard Variable Rate (SVR) is. A Standard Variable Rate is an interest rate set by the lender. It is the higher rate you usually move on to once your mortgage deal is over. It is not directly linked to the Bank of England Base Rate, but can be affected by it.

Discounted rate – this is where a lender offers you a percentage discount off their Standard Variable Rate (SVR), for a set period of time. The rate however is variable and moves up and down in line with the lender’s SVR.

Tracker rate – this rate is very similar to the discounted rate, but it tracks the Bank of England Base Rate instead of the standard variable rate. Therefore the monthly mortgage payments are variable and will increase or decrease as a result of any change in the Bank of England rate.

In short, a variable rate change is determined by the lender, a tracker rate change is determined by the Bank of England.

How is mortgage affordability calculated?

Affordability is a test that lenders use to assess whether an applicant can meet their mortgage repayments both now and in the future.

To do this, a lender will assess what sources of income the applicant has and what outgoings they have each month. This could include unsecured loans and credit card repayments, utility bills, council tax , and insurances as well as costs for childcare, school fees, gym memberships, food, and season tickets.

There are also red flags that might prevent your mortgage application from being accepted, such as regular amounts spent on gambling, and lending or gifting large sums of money to family and friends.

Every lender has their own set of affordability rules but if you are planning to apply for a mortgage soon, it is worth noting that most lenders ask to see at least three months’ worth of bank statements. Therefore, it is a good idea to practise good financial habits leading up to this, and of course, beyond.

Can mortgage offers be extended?

Most lenders will make a mortgage offer that lasts for between three and six months, but this will vary from lender to lender. The mortgage offer is issued once a lender is comfortable with the loan amount requested, the applicant’s circumstances and the property to be purchased.

Depending on the lag time between the initial mortgage offer and the requirement to extend it, some lenders may ask you to pick a new product from their current mortgage rates, while others might complete a new credit check to make sure your finances haven’t changed in the intervening period.

Can you switch mortgage providers?

You can switch to another mortgage provider whenever you want to (this is known as ‘remortgaging’), but most borrowers only do this when their current mortgage deal is due to end. This is because they would normally be charged a penalty for doing so. This penalty is called an Early Repayment Charge (ERC). Details of the exact ERC are always provided in an offer letter from the lender.

ERCs vary from lender to lender so, depending on your circumstances, it might make sense to pay the ERC if you can get a much better deal elsewhere. If you’re in any doubt about what is the best option for you, it makes sense to speak to a mortgage broker to help you make an informed decision.

Many lenders also allow overpayments. This is where the borrower decides to pay a larger amount of money back than the committed monthly mortgage payment. This can be as a one-off, lump sum payment or a regular monthly amount. Again, each lender will have strict rules about how much can be overpaid each year but if you have the means, it is usually worth reducing the amount you owe.

There are plenty of rules and regulations when it comes to mortgages but the above is a good starter for ten for those who are unfamiliar with how mortgages work. If you have any concerns about which mortgage would suit your circumstances, then always seek the advice of a financial adviser or mortgage broker.

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