A mortgage is simply a secured loan, with the security taking the form of a property.
A mortgage is typically provided to finance the purchase of that property, and for most people their main form of borrowing is the mortgage on their house or flat. Mortgages tend to be taken out over a long term, with most at one time running for 20 or 25 years. Rising property prices, however, have meant that mortgage terms have increased, with around 40% of them now having terms over 25 years, and half of that figure having terms over 30 years.
Whether a mortgage is to buy a house or flat, or to ‘buy-to-let’, the factors considered by the lender are much the same. The mortgage lender, such as the building society or bank, will consider each application for a loan in terms of the credit risk – the risk of not being repaid the principal sum loaned and the interest due.
Applicants are assessed in terms of:
- Income and security of employment – the amount borrowed will be based on a multiple of the applicant’s income (the loan to income ratio), although this will be capped at 4½ times their income
- Existing outgoings – for example, utility bills, other household expenses and school fees. The lender will undertake an affordability assessment to assess whether the applicant can afford the monthly repayments
- Future problems – the lender must look ahead and stress test the applicant’s ability to repay the mortgage taking into account possible changes to their lifestyle, such as redundancy, starting a family or having another child, or taking a career break
- Loan to Value – the size of the loan in relation to the value of the property being purchased which is referred to as the loan-to-value ratio.
A second mortgage is sometimes taken out on a single property. If the borrower defaults on their borrowings, the first mortgage ranks ahead of the second one in terms of being repaid out of the proceeds of the property sale.
Types of Mortgage
The most straightforward form of mortgage is a repayment mortgage. This is simply a mortgage in which the borrower will make monthly payments to the lender, with each monthly payment comprising both interest and capital.
The key advantage of a repayment mortgage over other forms of mortgage is that, as long as the borrower meets the repayments each month, they are guaranteed to pay off the loan over the term of the mortgage.
Risks of Repayment Mortgages:
- The cost of servicing the loan could increase, when interest is charged at the lender’s standard variable rate of interest. This rate of interest will increase if interest rates go up. Mortgage repayments can rise significantly at the end of a fixed-rate deal when they revert to the standard variable rate.
- The borrower runs the risk of having the property repossessed if they fail to meet the repayments remember, the mortgage loan is secured on the underlying property.
As the name suggests, an interest-only mortgage requires the borrower to make interest payments to the lender throughout the period of the loan. At the same time, the borrower generally puts money aside each month, into some form of investment.
The borrower’s aim is for the investment to grow through regular contributions and investment returns (such as dividends, interest and capital growth) so that at the end of the mortgage the accumulated investment is sufficient to pay back the capital borrowed and perhaps offer some additional cash.
The main risks attached to an interest-only mortgage from the borrower’s perspective are:
- Borrowers with interest-only mortgages still face the risks that repayment mortgage borrowers
face – namely that interest rates may increase and their property is at risk if they fail to keep up the payments to the lender.
- There is also an additional risk that the investment might not grow sufficiently to pay the amount owing on the mortgage. In the example above, there is nothing guaranteeing that, at the end of the 25-year term, the investment in the fund will be worth £100,000 – indeed, it might be worth considerably less.
An offset mortgage is a simple concept which works on the basis that, for the calculation and charging of interest, any mortgage is offset against, for example, any savings you may hold.