What is a Mortgage? How it Works
A mortgage is the type of loan you get to buy a home or land, and you pay it back with a monthly repayment, often over 25 or 30 years, after making a deposit when you first get the loan.
If you need to borrow money to buy your home, a mortgage is the type of loan you’ll need. Unlike a personal loan, a mortgage will be secured against the property you are buying. That means if you fail to keep up your repayments, the lender will have the right to repossess your home.
The mortgage is secured over a specific term, typically up to 25 or 30 years. You then make monthly repayments until the end of that term, at which point you own the property outright.
» COMPARE: Mortgage rates and deals
You can’t normally get a mortgage to cover the entire cost of the property purchase ‒ the maximum you will usually be able to borrow is around 95% of the property’s price. So you need to put a minimum of 5% down as a deposit, but the bigger your down payment, the more mortgages you will have to choose from and the lower your repayments will be.
You’ll need to pay interest on the money you borrow. Usually, the mortgage will have a lower interest rate for the first few years, after which you move onto the lender’s standard variable rate (SVR). The SVR is set by the lender and can be increased at any time, so it’s usually a good idea to remortgage ‒ or switch ‒ to a new mortgage as soon as your initial rate runs out.
The interest charged on your mortgage is not the only way that lenders make money from borrowers though. Many mortgages also come with an arrangement fee (sometimes called a product fee) which you have to pay just to secure your chosen rate, while there may also be valuation fees and administration fees to budget for.
Types of mortgage
Mortgages come in two main forms ‒ fixed rate and variable rate.
With a fixed-rate mortgage, your interest rate ‒ and therefore your monthly repayment ‒ is set in stone for a certain period, irrespective of changes to the Bank of England interest rate. So, if you take out a two-year fixed-rate mortgage, then the interest rate on that loan won’t change for those two years. Once that period is up, you’ll move onto your lender’s SVR for the rest of your mortgage term or until you remortgage onto another deal.
» MORE: When is it time to remortgage?
With a variable rate, things are a little more flexible. Some variable rates are called trackers, because the rate charged follows the base rate set by the Bank of England. So if the base rate goes up by 0.5%, so too will your interest rate, and consequently your monthly repayment. By contrast if the Bank of England reduces the interest rate, your monthly repayment will fall.
Then there is the discounted variable rate. This follows the lender’s SVR, but at a discount for a set period. So for example it might charge a rate of 2% less than the SVR for two years. Lenders can change their SVR at any time however, irrespective of what happens to the bank base rate, which does make them more unpredictable.
Variable rates tend to be lower ‒ at least initially ‒ than comparable fixed-rate mortgages. The risk with a variable rate is that your costs might rise if interest rates go up.
Can I get a mortgage?
All lenders have rules over who they will lend to. For example, you will need to be at least 18 years old, while most lenders have a maximum age you can be at the end of your mortgage term.
You will also need to be a UK citizen, or have the right to reside here, and the property you are buying will need to be in the UK, too.
Lenders will also want to go through your finances to ensure that you can afford the repayments. This means establishing precisely how much you bring in each month, for example by consulting your payslips or tax return, as well as what you spend each month.
This will encompass regular household bills like council tax and your phone bill, as well as things like your credit card bill, childcare and travel.
Lenders don’t just want to check that you can afford the mortgage today ‒ they also want to be confident that the mortgage repayments will remain affordable should circumstances change. As a result they will check to see if you could still afford the repayments if interest rates rise, which would push the size of your mortgage repayment up. They are looking for a level of flexibility in your finances.
Lenders will also run the rule over your credit record. This details your past experience with credit, from mortgages and credit cards to certain bills like your phone and energy bills. This will give them an idea of how good you are at managing credit.
Can I afford to buy a house?
Exactly how much a lender is willing to offer you will vary according to your circumstances. There is a cap in place, which means that only occasionally can lenders offer you more than 4.5 times your annual income as a mortgage ‒ though the actual amount they offer you will come down to things like your income, your profession and your history with debt.
However, it’s worth working out for yourself what level of monthly repayments you would be comfortable with ‒ just because a lender is willing to lend you £300,000, that doesn’t mean that you would be happy with how the monthly repayments on a loan of that size.
» MORE: How much mortgage can I afford?
John Fitzsimons has been writing about finance since 2007. He is the former editor of Mortgage Solutions and loveMONEY and his work has appeared in The Sunday Times, The Mirror, The Sun and Forbes. Read more