Defaqto

Different types of mortgage

A mortgage is a loan secured against the value of your home and is usually repayable over 25 years, although the mortgage term can be  for a shorter period such as 10 years.

When applying for a mortgage, you can usually borrow three times your annual income or 2.5 times joint income. During the house price boom, lenders were willing to lend up to five times salary in some cases, but since the credit crunch, lenders have become much more stringent as to how much they will lend and to whom.

Funding problems in the wholesale mortgage market have made it very difficult to borrow 100 per cent or more of the value of your home and lenders are demanding a deposit of at least 10 per cent, some as much as 25 per cent.

In any event, borrowing 100 per cent is clearly risky as you will fall into negative equity if house prices fall.

If you fail to maintain your repayments, the lender can start repossession proceeding after just three months of arrears. Some lenders, such as Northern Rock, are pursuing homeowners after only one month of arrears.

There are two main ways you can repay your home loan, either via:

• a repayment mortgage, or
• an interest only mortgage

Repayment

This involves paying back the capital and interest of the mortgage on a monthly basis. Although this will be more expensive than an interest-only mortgage, you have the peace of mind of knowing that at the end of the term, you will have repaid the mortgage in full.

Repayment mortgages provide certainty of capital repayment and are not dependant on the investment returns of a savings scheme.

Interest only

This means you pay off only the interest on the loan each month and nothing towards the original lump sum, or ‘capital,’ that you owe.

With an interest-only mortgage, you need to set up a savings plan, such as an ISA, so that the proceeds can be used to pay off the mortgage.

When house prices are high, an interest-only mortgage may be the only affordable option for some buyers, but this should not be an excuse to ignore the need to put in place a saving scheme to run alongside the mortgage.

You are taking a risk with an interest-only mortgage because, while your savings plan might perform well and you could end up with some cash left over once you have paid off the mortgage, the scheme could just as easily fall short, leaving you with an outstanding debt and no way of paying it off, without selling your home.

ISAs are a good way to save as they are tax efficient (the proceeds are tax free) but you should take advice on appropriate funds to invest in.

Some people who opted for endowment policies in the 1980s and 1990s experienced disappointing returns and faced significant shortfalls when they came to pay off their mortgages.

Do not fall behind on payments to your ISA or whatever other investment scheme you set up to pay off the mortgage. It is up to you, not your lender, to make sure you maintain payments.

Although the choice of mortgages may seem daunting, the UK mortgage market has traditionally been highly competitive.  

Since the onset of the credit crunch, however,  it has become more diffcult to obtain a mortgage if you want to borrow a high loan to value, have little or no deposit, or you have a poor credti history.

Standard variable rate

This will move up and down with moves in the Bank of England base rate, with most lenders charging around 1.5-2 per cent over base rate. Some lenders charge nearly 2.5 per cent over base rate, so accepting to pay your lender’s SVR is an expensive choice.

If you have been on a discounted rate, your mortgage rate will normally revert to your lender’s SVR at the end of the discount period, so it is a good idea to start shopping around for a new deal a few months in advance.

Fixed rate

If you think Bank of England base rate is going to rise, it may be a good idea to take out a fixed rate, whereas if you think it is at, or near, its peak, a tracker mortgage may be more appropriate.

Even if you think base rate might rise slightly, if you are on a tight budget, you may want the peace of mind of knowing exactly what your payments will be each month, so you may still want a fixed rate.

Fixed rates are available for up to 25 years, but in practice most people take fixes of 2-5 years only.

But most fixed rates come with early redemption penalties which can make switching mid-term very expensive.

So if you sign up for a fixed rate, you need to be sure that you will stick with it for the duration of the fix.

Discount rate

These mortgages offer a discount off the lender's SVR. Although the initial rate may look attractive, remember that the rate is variable and will go up and down with the SVR, which will, in turn, move in line with base rate.

At the end of the discount period, your mortgage will normally revert to your lender’s SVR.

Capped rate

These mortgages charge a variable rate, with a cap which the interest rate cannot exceed. This means that although your interest rate will move up and down with base rate, it cannot exceed the capped rate.

This means that you will benefit from all the falls in base rate, but any rises cannot exceed the cap. Also make sure you do not confuse the initial 'pay rate' with the 'capped rate.'

Tracker

These mortgages are charged at a fixed margin above or below base rate and move up and down when base rate moves.

The advantage of a tracker mortgage is that the margin you pay below or above base rate is fixed at the outset, so your lender cannot increase this margin (as it can with standard variable rates).

For instance, a few years ago, the margin between base rate and the typical SVR was typically 1.75 per cent. Today it is more likely to be 2-2.5 per cent over base rate.

Offset

With an offset mortgage, you deposit your savings in an account with the lender and your mortgage is then reduced by this amount. So, if your mortgage is £100,000 and you have £5,000 in a savings account, your mortgage balance will be regarded as being £95,000 and you will only be charged interest on this amount.

As your savings are being offset, you don’t have to pay interest on them which is why offset mortgages are more tax efficient for higher rate taxpayers.

Offset mortgages also allow you to make large lump sum payments to reduce the size of your mortgage, making them attractive to individuals in receipt of large bonuses, commissions or who have a fluctuating income.

By offsetting your savings against your mortgage, you will pay less mortgage interest, less tax and if you make overpayments from time to time, you will clear your mortgage more quickly.

Buy to let

Investment in rental accommodation remains popular and many lenders offer  buy to let (BTL) mortgages, often at rates similar to standard mortgages.

The rental income should normally cover the mortgage payments by 125 pr cent, thereby leaving you with some spare cash to cover repair and maintenance, insurance, voids (when the property is empty) and property related bills such as council tax.

Being a landlord is a serious and time consuming business so you should take advice before entering this market. For more information, read our Guide to buy to let mortgages:

Most lenders will lend up up to 75 per cent of the property’s value, but lending criteria have been tightened since the onset of the credit crunch.

There are many different types of BTL mortgage, from fixed rate to discount and trackers.

It is normally advisable to take out a BTL mortgage on an ‘interest only’ basis, as mortgage interest can be offset against tax owed on the rental income.

This means that if you have a large interest only mortgage, the interest (and other tax deductible expenses) may reduce, or even wipe out, your tax liability.

Flexible mortgages

Flexibile mortgages allow you to make overpayments, underpayments and even to take payment holidays.

It is preferable to opt for a mortgage which charges interest on a daily basis as this will reduce your debt more quickly than if your repayments are applied on a monthly or annual basis.

Having the interest applied on an annual basis is a shocking rip-off as none of your payments throughout the year are actually applied to reduce your mortgage debt until 31 December!

This means that if you were to redeem your mortgage shortly before the end of a payment year, none of that year’s mortgage repayments would be included in the redemption calculation.

Sub prime

If you have a tarnished credit history, you may have difficulty accessing ‘prime’ mortgages, which are only available to creditworthy borrowers.

You will be deemed to be an ‘adverse credit risk’ if you have ever had mortgage arrears, been bankrupted, have County Court Judgments (CCJs), or defaulted on loans or hire purchase agreements.

If you have a patchy credit record, you may only be eligible for a ‘sub prime’ mortgage which will be charged at a higher rate of interest than a standard mortgage.

Since the onset of the credit crunch, lenders are being much more selective as to whom they will lend to so even minor misdemeanours, such as missing a mobile phone payment, may now count against you.

Sub prime mortgages have also become more difficult to obtain generally because of the higher risk of default.

Self certification

If you are self-employed, a contract or temporary worker, you may be offered a self certification mortgage, whereby you self certify your income, without having to provide proof of earnings.

These mortgages are charged at a higher rate of interest because lenders regard the self employed as higher risk than those who are in employment.

In some cases, proof of earnings may be asked for in the form of trading accounts for the previous three years or your self assessment tax return.

But always check whether you can get a standard mortgage first as some lenders may be willing to give a self employed person a standard mortgage, providing you can show other sources of income or have equity in other property.

Fees

Taking out a mortgage is an expensive business, so you need to factor in the cost of the arrangement fees, valuation, survey, legal fees and sometimes a higher lending charge (the latter is imposed to protect the lender if you have a  high loan to value mortgage).

Some lenders will contribute towards valuation and legal fees, although the latter may be contingent on you using a solicitor of your lender’s choice.

Early repayment charges (ERCs)

Discounted and fixed rate mortgages often come with early repayment charges to discourage you from moving before theend of the discounted rate.

Some lenders even charge ‘overhang’ ERCs for one or two years after the discounted deal has ended. Avoid mortgages with higher lending charges if you possibly can.

Free valuations and legals may look attractive but check that you are not paying for these indirectly via a high arrangement fee or interest rate.

Buildings insurance

This is a compulsory insurance if you have a mortgage. Some lenders will try to sell you their own buildings (and contents) insurance because insurance companies pay them generous commissions for selling such products.

It is illegal for a mortgage lender or estate agent to force you to purchase buildings insurance in order to obtain a mortgage, although some may try to give you the impression that it would be in your interests to do so.

Some lenders will also offer you mortgage payment protection insurance (MPPI), which will cover you for accident, sickness or unemployment (ASU).

Rather than accepting these offers, it is advisable to consult an IFA or mortgage broker who can scan the entire market and advise you on appropriate products.

Income protection may be more appropriate as it will pay you an income if you are unable to work at any time up to retirement, and not just for one year.

Don’t overborrow

Don’t borrow more than you can afford by inflating your earnings as no one knows the future direction of interest rates or whether you will be able to obtain a discounted or fixed rate mortgage in the future.

If you over commit yourself, you could find repayments impossible to service and at worst, your home could be repossessed by the lender or you could get a criminal record for fraud if you have lied about your income.

Annual Percentage Rate (APR)

Lenders are obliged to quote a mortgage’s APR.  This should reflect the interest rate, plus any associated costs, so that you can compare quotations.

Home information packs

Anyone putting a property on the market must either have ordered a home information pack or have one in place already. Packs are expected to cost vendors around £300.

HIPs must include:

• an index of the contents of the pack
• evidence of title
• sale Statement (which must summarise the terms of the sale)
• standard Searches (ie local, drainage and water)
• commonhold information (if applicable)
• an Energy Performance Certificate
• leasehold information including a copy of the lease and information on service charges and insurance (if applicable)
• new home warranty (if applicable)
• where appropriate, a report on a home that is not physically complete.
• commonhold information (including a copy of the commonhold community statement)

Authorised documents include:

• guarantees and warranties
• other searches