Best Loans Articles

Most people living in Britain today have the desire to own their own home, if they don’t already. As this is usually the most expensive item that any of us are ever likely to buy, most home buyers will require some sort of additional funding, or loan, to assist with the purchase of the property and this funding normally takes the form of a mortgage.

Most of us are familiar with the term “Mortgage”, even if we have never had a mortgage in our own names, but what exactly is a mortgage and how do they work?

The literal translation of the word mortgage means “a promise to pay” and therefore the person borrowing money on a mortgage is known as the “mortgagor” and the lender who provides the loan is known as the “mortgagee”. Most individuals would think that these terms would be the other way round, however, once the true definition is known it is fairly obvious that the individual who is borrowing money is making a promise to the lender that he will repay the loan and therefore becomes the “mortgagor”.

The amount which can be borrowed on a mortgage is determined by the value of the property and the income of the borrower(s).  In general terms it can be said that the smaller the proportion of the value of the property which is to be borrowed, and the higher the income of the borrower in relation to the mortgage payments, the more attractive the terms of the loan and the interest rate will be.  Normally, it will be possible to borrow up to three times the borrower’s income, or in the case of joint borrowers with joint income prospect, two and half times the joint income. However, there are many lenders these days who are prepared to lend in excess of these amounts, some will even lend up to five, or more, times income. This may seem an attractive proposition to someone wanting to buy their dream home, but remember that the monthly repayments will be much higher on such a loan and a potential borrower should carefully assess the affordability of a mortgage before proceeding, as they may end up not being able to afford to live as they would like to, particularly if interest rates were to increase.

The term of years available on a mortgage can vary enormously, depending on the requirements and personal circumstances of the borrower(s). Usually, the minimum term of a mortgage loan is five years, with the maximum term often going up to thirty-five or even forty years. It is even possible to take the term beyond normal retirement age, providing that proof of suitable retirement income can be provided, such as pension benefits. The longer the term of the loan, the smaller each monthly payment towards the repayment of the capital will be, on the other hand, interest will be payable for longer, making the overall cost of the loan greater. The normal term of a mortgage is usually twenty or twenty-five years, as this seems to reach a reasonable compromise between monthly repayments and the total amount, which has to be repaid over the term.

There are two basic methods of repayment.  The first method is a repayment, or capital and interest, mortgage. With this repayment method, the loan is repaid by instalments, so that some capital is repaid each month in addition to your monthly interest payments, in much the same way as any other loan would be repaid. This method involves the lowest risk as the loan is guaranteed to be repaid at the end of the term, providing that the monthly repayments have been maintained, but may be less attractive for borrowers who move house fairly frequently.  This is because in the early years of a loan very little capital is paid off, and the bulk of each monthly payment consists of interest. As the term progresses and the capital balance starts to reduce, a higher proportion of capital is repaid each month and the interest element reduces, up to the point where, at the end of the term, almost the whole of the monthly repayment is capital.  Borrowers who use the repayments method will often be required to take out life insurance, which will be sufficient to pay off the loan in the event of their death during the mortgage term.

Alternatively, the mortgage can be arranged on an “interest only” basis, so that no capital is paid until the end of the mortgage term.  The idea behind this type of mortgage is that the amount of money which under the repayment method would have been paid each month to the lender is used instead to pay into an investment policy or plan which all being well should achieve a sufficient value by the end of the mortgage term not only to repay the capital of the loan but also to provide a lump sum bonus to the borrower. This method of repayment poses a higher risk than the repayment method, as there are no guarantees that the investment vehicle will provide sufficient funds to cover the outstanding balance of the loan.

For borrowers who are willing to accept the risk that the value of an investment policy or plan may fall short of the capital which must be repaid, “interest-only” mortgages can be very attractive, particularly if the mortgage loan is a long-term one and they can maintain their investment for its full term and thereby reap the full benefits of long-term growth.  This method is also advantageous to borrowers who are likely to move house reasonably frequently - perhaps more than once every ten years.  There are a number of different types of investment policy or plan which can be used to repay a mortgage, and it is possible to combine one or more different investments, including policies or plans which the borrower may have commenced previously.  The most common type of policy, however, is an endowment policy, and this can provide a wide range of incidental benefits, such as life insurance and critical illness insurance. Other repayment vehicles could include an investment ISA (individual savings account), which is a tax efficient method of building a lump sum, or a personal pension plan, whereby the tax free lump sum (maximum 25% of the fund value) which can be taken at retirement age is used to repay the mortgage.

Most mortgages have variable payments.  That is to say, the amount of the interest payment changes from time to time in accordance with general fluctuations in interest rates.  However, schemes are available which offer fixed interest rates, or rates which move within fixed limits or which start at a relatively low level and increase after an initial period.  Normally, the least complicated type of loan is cheapest overall and is least likely to have early redemption penalties for repayment in the first few years of the mortgage. The main types of mortgage deals are as follows:

Standard variable rate This is the normal rate of interest which would be charged by a lender when no particular deal has been arranged, such as a fixed or discounted rate. Most mortgages revert to the standard variable rate once any initial incentives offered by the lender (e.g. fixed rate) have expired.

Fixed Rate This is where the interest rate charged on the mortgage loan is fixed at a set rate for an initial period of the mortgage. The term of the fixed rate can vary, but the most common terms are usually between 2 and 5 years. Normally, the longer the duration of the fixed rate period, the higher the interest rate charged will be. The main advantage of a fixed rate mortgage is that the monthly repayments will not alter during the fixed period, regardless of movements in the interest rates, thus allowing a borrower to manage their budget effectively, without worries of increased monthly payments. The main disadvantages are; firstly if interest rates go down, the borrower will be paying more interest than necessary and secondly, if interest rates rise, there could be a nasty shock in store for the borrower at the end of the fixed rate period when the monthly repayments could jump significantly.

Discounted rate This is where the lender offers a discount on the standard variable interest rate for an initial period of the mortgage. The monthly repayments will still vary in accordance with movements in the interest rate, but will be at a cheaper rate. The actual amount of discount is usually more over a shorter term than it would be on a longer discounted period, although the actual monetary saving usually works out about the same. For example, a discount of 2% for one year would give the same level of saving as a 1% discount for two years. The advantage of a discounted mortgage is that it allows the borrower slightly more disposable income for the initial period of the loan, which can often be useful when there is decorating to be done and new furniture to be purchased.

Capped and collared rate This is where the interest rate charged is variable, but can not exceed a predetermined level. In the case of a capped mortgage, the rate can reduce if the general interest rates should fall, but will not increase beyond a certain level if they rise. A collared mortgage works in exactly the opposite way, interest rates can rise but will not fall below certain levels. Although there is an obvious advantage to the borrower with a capped rate, a collared rate is more likely to benefit the lender and is therefore less attractive to the borrower. It is possible to obtain a capped rate mortgage or a collared rate mortgage independently of each other, as well as a loan which combines both elements.

Tracker rate This is where the interest rate charged follows one of the main indexes. In most cases this would be the Bank of England base rate, although some mortgages (particularly commercial and buy to let) track the LIBOR rate (London Interbank Offered Rate). A tracker mortgage follows the chosen index plus a margin, for example a mortgage may offer a rate of Bank of England base rate+ 1.5%. If the index rate were to alter, either up or down, the tracker mortgage rate must also move in accordance with the change within one month of the rate changing.

Flexible mortgage This is where the borrower has the flexibility within their mortgage to alter their monthly repayments. It is possible to overpay on the mortgage thereby reducing the outstanding balance of the loan quicker. It is also possible to make underpayments, or even take payment holidays in times of hardship, although this option is often subject to previous overpayments having been made. It is also possible to make lump sum repayments on the mortgage at any time without incurring any early redemption penalties. Flexible mortgages can be particularly useful to those people who have irregular income patterns, such as the self-employed, or people who receive bonus payments. By making regular overpayments on a flexible mortgage, it is possible to reduce the term by several years and save a large amount of interest in the meantime.

Offset mortgages These are often an extension of a flexible mortgage. A savings account is set up alongside the main mortgage account.  Any overpayments, lump sum repayments or other savings may be deposited in the account. The balance of the savings account is then “offset” against the outstanding mortgage balance, effectively reducing the level of the loan and therefore reducing the interest charged. The advantage of this system is that, unlike a flexible mortgage overpayment where money has been paid off a loan, the funds are placed in a savings account and are therefore easily accessible should they be required.

In summary, there are many different types of mortgage deal available on the market today, from a vast range of lenders. What could be a great benefit to one borrower may be completely unsuitable to another and therefore it is important to fully understand the various options available to ensure that you obtain the best mortgage for your own personal circumstances. Many lenders have mortgage and loan calculators on their websites, which help a potential borrower assess their affordability and how much they can borrow, along with tools which show the benefits of overpayments and offsetting. It is also worth taking advice from an independent mortgage broker, even though they may charge a fee for their services, as they will be able to help guide you through the potential minefield of choosing and arranging a mortgage. A mortgage is usually the biggest financial commitment anyone ever makes, take your time, do the research and make sure you get the right mortgage deal to suit your needs.