Mortgages - the Basics

A mortgage is simply a loan you take out to purchase a home. Your mortgage is a secured loan. In effect you are borrowing money directly against the value of your house or property. This guide explains how big a mortgage you may borrow, what your mortgage will cost and explain some of the ways you may pay your mortgage back.

• Why do I need a mortgage?
• How much can I borrow?
• What will it cost me?
• How do I pay back what I've borrowed?

Why do I need a mortgage?

The most money you are ever likely to spend in one go will be on a pile of bricks and mortar. Few of us are independently wealthy and that means that most of us take out a loan - a mortgage - to buy our home. The rate of interest we pay for this home loan is generally determined by base interest rates prevailing in the market. Base interest rates are set by the Bank of England.

The standard variable mortgage rate over the first six years of the new millennium has averaged 5.86%. Back in the 1950s, it was 4.99% and there were only six rate changes over the decade. In the 1960s, the average rate was 6.75%; for the 1970s, it was 10.07%. By the 1980s, the average had risen to 12.83%, dropping back to 8.58% in the 1990s (Source - Council of Mortgage Lenders: May 2007).

Up until November 1984, the Building Societies Association set an official mortgage rate and, no matter which institution you borrowed from, that would be the rate you would get. A truly free market in mortgage rates only became possible for the first time following the 1986 Building Societies Act.

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How much can I borrow?

Whether you are contemplating a first mortgage, a remortgage or a new mortgage if you are moving, bear in mind that you cannot rely on the lenders themselves to give you "best advice" - your home loan lender is not under any legal obligation to do so.

As a rough rule of thumb you may generally borrow three times the first income plus half of the second income, or two-and-a-half times joint income. However, higher income multiples are not uncommon and in some cases lenders will allow you to borrow four and even five times income. Do remember that the higher the multiple, the greater the burden debt repayments will be, and your home may be repossessed if you do not keep up repayments on your mortgage.

Most lenders are prepared to offer you up to 95% of the property's value but most charge less interest with a bigger deposit. Remember also that if you borrow more than 75% of the asking price you may be required to pay a higher lending charge (HLC) as well. Not all institutions require this and some make a point of not doing so.

You can get a 100% loan and in rare cases even more but you may find that the interest rate at which it is offered is less competitive because the lender's only comfort is your ability to repay - there being no "cushion" in the value of the property.

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What will it cost me?

In general, you will be expected to have a deposit of between 3 - 10% of the asking price of the property you want to buy. Thus, if you were looking to purchase an "average" property with an asking price of around £175,000, most lenders will expect you to have between £5,250 and £17,500 to put down as a deposit.

You will have other expenses as well. Solicitor's fees, valuation, arrangement and HLC (Higher Lending Charge) costs soon mount up. You should allow between 1-2% of the asking price to cover these costs.

Finally, while house sellers face no tax bill (providing the property being sold qualifies as your sole or main domestic residence), purchasers may be required to pay Stamp Duty Land Tax. Properties worth less than £125,000 attract no duty but over that price it is payable on the full value of the property at a rate of between 1-4% depending on price.

Once you have taken account of all these costs, your basic mortgage choices are a variable rate, a fixed rate loan or a discounted rate, which offers a discount on the variable rate. Many fixed rate loans and discounted offers have a sting in the tail in that you are required to stick with your mortgage lender's variable rate for some years after your initial deal expires. This means you give up the right to shop around for another, cheaper deal unless you pay a stiff early repayment charge. Such penalties are designed to tie you to the lender after the cut-price period has ended. If you want to pay off all or part of your mortgage, you may face punitive costs which can be as high as six months' repayments.

Fixed rate mortgages fix your monthly repayment over a set period of time, regardless of what happens to interest rates in the market. After the end of the fixed rate period, your mortgage cost will revert to the lender's standard variable rate. Discounted rate mortgages peg the interest rate you are charged to a fixed amount below the variable rate. If the variable rate rises, so will yours, and likewise if its falls. Thus you are afforded some protection from higher interest rates but are also able to benefit from any cuts in interest rates.

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How do I pay back what I've borrowed?

Most mortgage loans are structured to run for a term of 25 years. Your basic choice is between a straightforward repayment mortgage and an interest-only mortgage with some form of investment attached to it with a view to it growing to pay the loan off at the end of the term. If you want the potential risk and reward of an investment-linked mortgage it makes little sense now to take out an endowment policy. There is no tax relief on the life assurance part of the policy - that was scrapped in 1984 - and the income return on your funds will have been taxed. It may make more sense if you want to tie your mortgage to an investment to consider an alternative investment option. One example could be an Individual Savings Account (ISA) mortgage. There is more flexibility in an ISA than there is in an endowment policy. While your investments may be affected by market performance, the charges are more transparent than with an endowment policy and ISA plans also benefit from certain tax advantages.

In recent years, a new form of mortgage deal has appeared in the market. These so-called flexible mortgages allow you to have one account which combines a home loan and a current account into one. So, if you take out say a £75,000 mortgage, and then you win £10,000 on the premium bonds, you can simply, without penalty reduce the size of your mortgage. Flexible mortgages may come with cheque books attached. So conversely, if you suddenly need an extra £5,000, you'll be able to write a cheque and in the process increase the overall size of your home loan to £80,000. Different lenders have different limits for the proportion of your home loan to property value that you may have outstanding at any one time.

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25 July 2007 © Moneyextra.com

Our senior editor Robin Amlôt recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.