What is a mortgage?
The most expensive thing that most people will ever buy is their home.
With the average price of a first home in the UK being around £210,000, the majority of people wishing to buy a property will need to borrow a significant amount of money.
A mortgage is the name given to a loan taken out to buy a property.
What’s involved in taking out a mortgage?
Before an institution that offers mortgages (the mortgage lender) will do anything else, they first need to check that the person taking out the mortgage (the mortgage borrower) can afford the monthly mortgage repayments that the lender will require.
For example, if you were to borrow £175,000 over 25 years (a typical timescale for a mortgage), your monthly repayments might be £915. The lender would look at the amount of money you have
coming in (income) and the amount that is going out (expenditure). The difference between the two gives the lender an idea of whether you can comfortably afford £915 a month or whether you might struggle. If you might struggle, chances are the lender won’t lend to you.
Also, most lenders won’t lend the whole amount needed to buy a house. For example, if a property is valued at £200,000, the lender might agree to lend 90% of that, i.e. £180,000. The borrower must save up the remaining amount – £20,000. This is called their deposit.
Once the lender has confirmed how much can be borrowed, it will then state the interest rate at which they are prepared to lend the money. Interest is what it costs the borrower to use the lender’s money. The amount of interest charged will vary depending on how likely the lender feels the borrower is to repay the loan. Those that the lender feels are most likely to get into financial difficulty are charged the highest rates as they are a greater risk to the lender. Those who can pay a larger deposit, will benefit from lower rates.
What other costs are involved?
The deposit isn’t the only amount of money a borrower will need before buying their first home. Can you think of any other expenses that might be involved in buying a house?
A solicitor will be involved in the house-buying process. Their fees will need to be paid. In addition, there is a special type of tax, known as Stamp Duty Land Tax (Land and Buildings Transaction Tax in Scotland, Land Transaction Tax in Wales), that is payable to the Government when a house is bought.
How is a mortgage paid back?
There are two main ways in which a mortgage can be repaid:
- A repayment mortgage
- The monthly mortgage repayment to the lender is made up of two parts – capital (the amount that has been borrowed) and interest
- The lender deducts the capital part from the amount the borrower owes
- The lender takes the interest part to cover its own costs and, in some cases, to make a profit
- Providing the borrower makes all repayments they will pay off their debt in full by the end of the mortgage term
- An interest only mortgage
- The monthly mortgage repayment only consists of interest
- The borrower must make a separate arrangement to save up the money needed to pay off the original loan at the end of the mortgage term
- This type of mortgage is riskier because if the borrower fails to save the full amount owed, they will not be able to repay the lender and the lender may then sell their house to get back the amount they are owed
Protecting a mortgage
Generally a mortgage should have financial protection so that if an unexpected life event occurs (like illness or death), the financial consequences are taken care of.
Let’s take a look at what those financial consequences might be:
- Jenna has taken out a repayment mortgage over 25 years for £175,000
- Her monthly repayments are £915
If Jenna dies, the mortgage will have to be repaid (such loans are repayable on death). A life assurance policy providing cover of £175,000 over 25 years would ensure that the money was available on her death to repay the mortgage.
If Jenna becomes so ill that she is unable to work, she may no longer receive an income. With no income she’d be unable to make her monthly repayments. An income protection plan will pay out a monthly income in these circumstances, meaning that Jenna would not have to worry about keeping a roof over her head and could focus on her recovery instead.
A word of caution
A mortgage is a big commitment. At the first sign of financial difficulty it’s important to contact the lender as they may be able to help. Ultimately, lenders have the right to sell a property to get back the amount they are owed if a significant number of mortgage repayments are not made, but this is not a step that they like to take if it can be avoided.
With thanks to our partners over at the NMBA for content.
Up next week – FINANCIAL PROTECTION!