Types of mortgage

When applying for a mortgage, conventionally you can usually borrow three times your annual income or 2.5 times your joint income. However many lenders are now using ‘affordability’ rather than income multiples to determine whether, and if so, how much, they will lend. This takes account of your income and expenditure and your bonuses, and the calculation methodology used to determine affordability may vary from lender to lender and is often reviewed.

Funding problems in the wholesale mortgage market have now made it impossible to borrow 100% or more of the value of your home and many lenders are demanding a deposit of at least 10%; some as much as 25%. Typically the lowest interest rates are now only available to borrowers with a deposit, or equity, of 25% or more of the property value.

You will often see the term loan-to-value (LTV) used in relation to mortgages and this refers to the mortgage amount required as a proportion of the property value. So, if you have a £10,000 deposit for a £100,000 property you would require a £90,000 mortgage. This would be referred to as 90% LTV (mortgage amount divided by the property value; then multiply by 100).

In any event, borrowing a high LTV percentage is clearly risky as, if property prices fall, you may fall into negative equity, which is when the LTV exceeds 100%.

If you fail to maintain your mortgage repayments, it is possible that your lender may start repossession proceedings. If you are having financial difficulties it is generally best to seek advice from an organisation such as the Citizens Advice Bureau (www.citizensadvice.org.uk/) and to contact your lender.

They should be sympathetic and try to help you work through your difficulties. It is possible that the lender may agree to a payment holiday although interest would still accrue, or, if you have a repayment mortgage, the lender might agree to transfer some, or all, of your mortgage from a repayment to an interest only mortgage. The Government also has some schemes, which may be of assistance in certain circumstances.

Repayment versus interest only

There are two main ways you can repay your mortgage, either via a repayment mortgage, or an interest only mortgage. With some lenders it may be possible to have part of your mortgage on a repayment basis and part on an interest only basis.

Repayment

This involves paying back the capital and interest of your 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; provided that you make all the required monthly payments.

Repayment mortgages provide certainty of capital repayment and are not dependant on the investment returns of a savings scheme. Because of the way that repayment mortgages work be aware that in the early years of your mortgage a large proportion of each monthly repayment will repay the interest and only a small proportion will repay capital. Over time the proportion that repays the capital element will increase and, if you make all the monthly mortgage payments for the full term, the entire mortgage will have been repaid. If you have a repayment mortgage it is advantageous to have a mortgage that calculates interest daily.

Interest only

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

Some lenders have recently started charging a slightly higher interest rate for an interest only mortgage than for capital repayment mortgages.

This has the advantage of keeping costs to a minimum, because you are only paying the interest and none of the capital each month. But you will need to set up a repayment vehicle to pay off the mortgage at the end of the mortgage term. The repayment vehicle will generally be some sort of savings plan – such as an ISA, OEIC, unit trust or pension – and you should take professional advice on the type of repayment vehicle to choose.

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. While your savings plan might perform well the scheme could just as easily fall short, leaving you with an outstanding debt and no way of paying it off.

ISAs may be a good way to save, as the proceeds are largely tax free, but there are annual limits to the amount that you can invest. You should take advice on choosing suitable shares or mutual funds to invest in and keep the fund under regular review to ensure it is on track.

It is up to you, not your lender, to make sure you maintain payments and review your policy regularly.

Some people choose not to save, saying that they will pay off their mortgage by selling their home. If you do this bear in mind that you will still have to repay the capital and that this may cause you problems in the future.

Tracker mortgages

These mortgages are charged at a fixed margin above or below base rate, and move up and down when base rate moves. Typically a tracker mortgage will track the Bank of England’s base rate (technically referred to as the ‘Repo’ rate) but there are some mortgages that track LIBOR (London Interbank Offered Rate) instead. Please refer to our tracker mortgage guide for more details.

Offset mortgages

A current account mortgage combines a mortgage with one or more of the following:

a current account, a savings account, a credit card and an unsecured loan – all within one account. These types of accounts are ideal if you regularly leave money in your bank account or if you have savings that are only receiving a low rate of interest. Instead of receiving interest on your savings, this money is used to reduce the amount of interest you are charged on your mortgage. See our guide to offset mortgages for more information.

Using a financial adviser

Since November 2004, mortgages and mortgage advisers have been regulated by the Financial Services Authority (FSA) and financial advisers have since been split into three categories:

• Tied advisers: give advice only on mortgage products of the lender they work for;
• Multi-tied advisers: give advice on mortgage products offered by a limited range of lenders;
• Independent financial advisers (IFAs): who must give totally impartial advice and make recommendations from the entire market.

You can now do all the legwork online as there are several broker sites that will scour the mortgage market on your behalf but for full advice, you need to consult a mortgage IFA.

Commission

The adviser receives commission from the lender, which is typically a percentage of the loan. If you pay nothing directly to the adviser, you may well be paying indirectly via a higher arrangement fee or interest rate.

Fee offset – This involves the adviser offsetting his commission from the lender against his fee to you for advice. All advisers are legally obliged to disclose up front how they charge by issuing an initial disclosure document.

Direct only deals – The credit crunch has resulted in all lenders restricting the amount of mortgage lending in the last 18 months. They have achieved this by offering many of their best deals through their branch network or websites. Consequently if you arrange your mortgage deal via a mortgage broker you may not be offered the very best deals. If you wish to use a mortgage broker, but also be offered the best rates, then you must ask your broker if they advise and recommend all mortgages including ‘direct only’ mortgages.