Taking out a mortgage is typically the biggest financial transaction that an individual will ever undertake, so it is surprising (and unfortunate) that many of us know little or nothing about mortgages until we find ourselves going through the process of applying for one. This is a bit like a pilot learning the controls for a plane on the morning that they’re due to fly from London to New York! This lack of financial knowledge represents a fundamental failing in our schooling system and leaves the onus upon individuals to work out for themselves what a mortgage is, what its main features are, and what are the key features and pitfalls that a person needs to be aware of. Sometimes this task is not made easy when banks converse in jargon and legalese, rather than in plain English, so let’s walk through some of the main things that people need to be aware of when considering a personal home mortgage.
Understanding what a mortgage is:
A mortgage is effectively just a loan. A lender (normally a bank) agrees to lend you (the homebuyer) a sum of money, on the proviso that you agree to pay that capital sum back, plus interest, over an agreed period of time. This period of time is often referred to as the mortgage term. Another important feature of a mortgage is that it is a secured loan. All this means is that if you default on the mortgage (i.e. fail to make payments), then the lender has the legal right to take possession of your home and to sell it to recover their costs. So, in summary, a mortgage is just a very big loan that is secured against the property.
Mortgages come in many different flavours:
One of the main challenges that first time homebuyers are faced with is knowing which mortgage deal to opt for. A casual glance at a bank’s website will normally reveal that they sell fixed rate mortgages, flexible/variable mortgages, shared equity mortgages, tracker mortgages, and sometimes offset mortgages. Many of these terms will mean little or nothing to anyone who has not worked in the financial industry, so individuals are often very reliant on their bank’s mortgage adviser to explain them and make appropriate recommendations.
It’s worth taking the time, however, to read up on all of the main types of mortgages. I don’t have space in this article to go into them in detail but here is a quick summary of the main ones.
Fixed rate mortgages – As the name suggests, the interest rate is guaranteed to remain fixed for a certain period of time. For example, if you took out a 5 Year Fixed Rate mortgage, then the rate would remain fixed for the first five years, before moving onto a variable rate.
Flexible or Variable rate mortgages – The rate is variable. This means that it may go up or down depending upon movements in the general base rate. In other words, whether the interest rate goes up or down is influenced by general economic conditions. These mortgages are sometimes referred to as Flexible Mortgages, as they normally allow you to make additional lump sum payments, or to increase your monthly payment amounts if you wish to pay off the mortgage early.
Shared Equity Mortgages – In these tough economic times, it’s become very difficult for first time buyers to afford to become home owners. In response, several schemes have been introduced with the aim of reducing the initial burden. In Scotland, for example, the LIFT scheme (Low cost Initiative for First Time buyers) means that the government will provide a loan for between 20% to 40% of the property purchase price.
Offset mortgages – Some banks enable their customers to link their mortgage, savings account and their current account. The idea is that, for those with high savings, it reduces the amount of interest that is required on the mortgage, whilst still providing the individual with the ability to access their savings should they need to do so. For example, if you took out a mortgage for £100,000 and have savings of £20,000, then you would only pay interest on £80,000.
How mortgage payments work:
Having opened a mortgage, you will be required to make monthly payments on the mortgage. A useful tip is to ask the lender to arrange for the payment to be taken just after your pay day so that you will always have sufficient funds in your current / checking account. Most mortgage payments work on a capital and interest repayment model. Put more simply, this means that your payment amount goes partly towards reducing the outstanding capital amount and partly towards paying the interest generated on that outstanding capital sum.
The sooner you pay off the mortgage, the less costly they are:
Let’s say that you need a mortgage of £100,000. If you can afford to pay it off in 10 years, then you will end up paying a lot less than if you arrange to pay the mortgage off over 25 years. The reason for this is that you will reduce the amount of interest that needs to be paid on top of the capital sum. However, you need to understand any restrictions that the lender might place on early repayment of the mortgage. For example, fixed rate mortgages often come with restrictions on whether you are allowed to make lump sum payments and/or increase your monthly payment amount.
You can switch to another provider:
Some mortgage holders mistakenly believe that they have no choice but to stick with their lender for the duration of their mortgage. This is not true. If you’re unhappy with your current provider (or see a better deal elsewhere), then it may be worth switching to another lender. You will need to weigh up the benefit (e.g. lower interest rate) against any fees that might be associated with switching your mortgage to another bank.
Arrange appropriate building insurance:
Alongside taking out a mortgage, you should ensure that you have taken out appropriate building and content insurance. It is usually recommended that homeowners arrange building insurance based on the cost of rebuilding the property rather than its current market value. The reason why building insurance is important is that it avoids a situation whereby your house gets destroyed (by fire, flood, etc) but you are still left owing the bank a big sum of money.
Speak to your bank if you get into difficulties with payments:
Struggling to keep up with mortgage payments can be scary, given the ultimate sanction that the lender has to repossess your home. If your circumstances change, for example through increased living costs or reduced household income, then it’s better to speak to your lender rather than hoping that the problem will go away. The lender may be able to offer advice (for example, on budgeting) and may be prepared to consider reducing the monthly mortgage payments by extending the mortgage term.