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Buying a home is one of the largest financial transactions most people make. So, unless you've won the lottery, that means getting a mortgage. But what exactly is a mortgage? In this 'how do mortgages work' UK definitive guide, we’ll take a deep dive under the hood of mortgages to see how they work.
We’ll talk about the different types of mortgage available, how interest is calculated, how much deposit you need and more. So, if you need a mortgage, particularly a specialist contractor or self-employed mortgage, this article will help you navigate through the myriad of options available.
A mortgage is essentially a loan to purchase a property, where the property itself provides security for the loan. Most mortgages are provided by banks and building societies, but specialist lenders are also available that provide mortgages to individuals who may not qualify for a loan from a mainstream lender.
Mortgages allow buyers to purchase a home they otherwise would not be able to afford. However, because the property provides security for the loan, the home is at risk if the buyer fails to keep up repayments. That’s why you should think carefully about how much you can afford to borrow before applying for a loan.
Our handy affordability calculator will let you know how much you can comfortably afford to borrow.
A mortgage is a secured loan typically paid back over a fixed term of around 25 years, but longer and shorter terms are available. Most lenders require the loan to be paid off by the time the borrower is 70 years old. So, someone aged 45 will only be able to get a mortgage for a 25-year term.
Mortgages can be taken out individually or jointly, where the income of you and your partner is counted towards the loan value. The amount lenders are prepared to provide will depend on a multiple of your individual or combined salaries. Most lenders will lend a maximum of 4x your joint income or 3.5x your individual income.
There are exceptions to this rule, however, especially for contractors, company directors and self-employed individuals whose incomes can vary. Such individuals are therefore advised to use a specialist mortgage broker who can search more than one lender to find the best deal.
Get in touch with the mortgage advisors at Wis Mortgage today for FREE advice about contractor or self-employed mortgages.find me a mortgage
Several types of mortgage are available; below we’ll cover the four main types and discuss the pros and cons of each:
With a fixed-rate mortgage, the interest rate is fixed for a period of between 2-5 years. The benefit of this type of loan is that the borrower is insulated against rises in interest rates and they know exactly how much they are going to pay each month. The downside is that if interest rates fall, the borrower will end up paying a higher rate than necessary.
Variable-rate mortgages are based on the lender's standard variable rate (SVR). Each lender is free to set its own standard variable rate, which helps to create competition in the mortgage market. However, lenders can change their SVR at any time, which means borrowers can end up paying more or less depending on which way rates are heading.
Tracker mortgages are similar to variable-rate mortgages, but instead of interest rates following the lender's SVR, they are tied to the Bank of England base rate. Lenders are free to set their own rates above the base rate. For example, if the base rate is 0.1% and the lender has a rate of 2.5%, the borrower will pay a total of 2.6% interest.
Discount mortgages are based on the lender's SVR, much like a standard variable rate mortgage. But they offer a discounted rate for a predefined period. For example, if the lender’s SVR is 5% and the mortgage has a discounted rate of 1.5%, the borrower only pays 3.5% interest for the duration of the deal. Discount periods are available from 1-5 years.
Interest represents a significant amount over the term of a mortgage, so it's prudent to know how these rates are calculated. The amount of interest you pay will depend on the type of mortgage you have, but to keep things simple, in this example, we’ll look at a typical fixed-rate mortgage.
Calculating interest on a fixed-rate mortgage is pretty straightforward. You simply need to multiply the interest rate by the amount outstanding on the loan.
Mortgage amount: £300,000
Interest rate: 3%
Annual interest charge: £300,000 x 3% = £9,000
Monthly interest charge: £9,000 / 12 = £750
It is reasonable to assume that the amount you pay each year will reduce as the mortgage is paid off. However, the amount you pay remains stable throughout the term of the mortgage due to something called amortisation.
At the start of a mortgage, most of the monthly payments are used to pay interest. As the mortgage progresses, more of the payments are used to pay off the outstanding debt. This method allows mortgage payments to remain relatively stable across the term of the loan.
Most lenders require the borrower to contribute towards the cost of the property. This is known as the deposit. Deposit amounts can vary considerably from lender to lender, but most mainstream lenders require a deposit of at least 10%.
For example, to buy a property with a value of £400,000, you will need a £40,000 deposit. The lender will then loan you the remaining £360,000. The total amount the lender will fund is known as the ‘loan to value’ (LTV) ratio. So, an LTV of 60% means the lender will fund a maximum of 60% of the purchase price.
As a rule of thumb, the higher the LTV, the less interest you have to pay. This is because the lender is taking on less risk. However, it is always advisable to compare rates from a few different providers because there can be a large difference between lenders, especially for specialist self-employed or contractor mortgages.
Most mortgages are subject to a fee paid to the lender. Fees can vary depending on the provider; some don’t charge a fee while others charge £2000 or more, so it’s a good idea to find out how much the fee is for any mortgage you are evaluating.
Be careful here, because some lenders offer a low headline rate, intending to make up the difference by charging a high fee. So, it’s always good practice to include the fee structure and interest rates when comparing mortgages.
The fee can be paid upfront or added to the cost of the mortgage. If added to the mortgage, interest will have to be paid on top, so it’s advisable to pay mortgage fees upfront if you can afford it.
If you would like to know more about mortgages, check out our how do mortgages work UK guide here. Alternatively, for more personalised advice, get in touch with the mortgage specialists at Wis Mortgages. We specialise in securing mortgages for contractors, company directors and self-employed individuals. Complete the contact form here to arrange a FREE consultation.Contact Us
As a mortgage is secured against your home/property, it may be repossessed if you do not keep up with the mortgage repayments.