Beginner’s guide to mortgages

A property mortgage is the biggest debt most of us will ever take on. So choosing the right one is vital. Tim Bennett explains the basics of mortgages and highlights the main pitfalls to avoid.

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One of the most important financial decisions you'll ever take is getting a mortgage. It's one of the biggest financial commitments most people make, alongside private school fees for their children, if they're lucky enough to be able to afford them.

So what is a mortgage? That's what we'll cover in this video, and what some of the key bits of jargon, plastered all over the newspapers, actually mean.

A mortgage is a secured loan. That makes it different from a loan that you might take out, for example, unsecured to buy a car or just simply by racking up credit card debt or using a store card. Those are unsecured. Now, the difference is very simple.

For a secured loan, a mortgage, you go to a bank, say, "I want to borrow £100,000", for argument's sake. The bank says, "That's fine, Tim, but we want the loan secured on an asset", that asset being the house you plan to buy. The deal is simple and it's a two-sided deal.

In return for that security, the bank will offer you a low interest rate, much lower than on, say, a car loan or a credit card or a store card loan. You can pick up mortgage rates for around 4% or 5% at the moment, depending on the period you go for. Whereas unsecured store card loans could cost you up to 30%. So that's the upside. The interest rate is low because the loan is secured, and that means if you fail to repay it or keep up with repayments, the bank reserves the right to seize your property and sell it and use the proceeds to repay the loan.

So a mortgage has one benefit upfront – the interest rate tends to be a lot lower than you can get on other loans, because the bank has a lot of security, in the form of your property. Now property prices can go down as well as up, which is why banks don't always lend, or certainly not any more, the full value of the property to somebody who wants a mortgage. The heady days, the ridiculous days before the financial crisis, are now long gone.

Loan to value

So that brings me on to my first piece of jargon related to mortgages: ‘loan to value’. (LTV). Now if you see that, what does that mean? What practical consequence does it have for you trying to get a mortgage? Well, here's how it works.

People who've seen my videos before will know that graphics are a particular forte of mine, so there's a house. Let's say that the value of the house on the open market is £100,000 and you plan to put down a £30,000 deposit. Lucky you.

That means you need a £70,000 loan or mortgage. Now, how do I know you've put down a £30,000 deposit? Maybe you can't afford a £30,000 deposit. The deposit is down to what you can manage to scrimp and save together, persuade parents or friends to give you, whatever it happens to be. So you've got a deposit from somewhere and the rest is the mortgage. So a combination of what's called ‘equity’, that's your bit, and a loan from the bank, secured on the property, makes up the funding for the £100,000 property.

Now, here, the LTV, as you'll sometimes see it quoted in the press, is simply that compared to that as a percentage. So here the LTV is £70,000, as a proportion of the value of the property. The loan to value ratio is 70%. In simple terms, basically the higher that is, the harder it is to get the loan. Now, back in the ridiculous days pre financial crisis, there were banks around that would say, "No problem, you could have LTVs of more than 100%, 125%”. You could actually borrow more than the value of the property from a bank. They'd even give you hints and tips as to what to do with the extra. So on a £100,000 property, this may sound a little mad, but it was happening, you could borrow £125,000. I'm not kidding, there were bank websites saying things like, "Well, book yourself a holiday. Buy a car with the extra."

Now that is madness and got a lot of people into big trouble, which is why LTVs tend to be a lot lower now, because of something called ‘negative equity’, which is the third bit of jargon I'll cover just now.

But here's my takeaway: the higher the loan to value ratio, naturally the higher the interest rate and the harder the mortgage will be to come across. So if you can, scrimp together as much of a deposit as you can get hold of, bringing down the loan to value ratio, you'll tend to find that better deals then become available.

Negative equity

Why are we no longer seeing loans in excess of 100% of the value of the property?

Well, unfortunately if you allow someone to borrow a huge amount of money and the value of the property then drops… So imagine, for example, if I take out the deposit altogether and I make the loan 100%. Imagine the whole thing, still following my scribblings here, is funded by a mortgage. The danger is this: if the value of the property then drops, which it could do, to £90,000, you are now in something called ‘negative equity’. That’s the danger of taking out loans that are a high proportion of the value of the property.

Negative equity means the property is not worth enough to pay back the loan. £90,000, if you sold the property tomorrow, won't pay back a loan of £100,000. That's a problem. It can leave you unable to move, for example. That's a trap that quite a few people unfortunately, knowingly or otherwise, probably unknowingly, fell into as property prices started to come off once we hit the financial crisis in 2007. That's why unfortunately banks are now being very, very conservative. Unfortunately, because it makes it harder for a lot of people to get onto the property ladder at all. Okay, so that's negative equity, what the Americans call ‘being underwater’.

Interest only or repayment mortgage?

Now, once you've decided how much you're going to borrow – £70,000 in my previous example – you've got a couple of choices. You can either go interest-only or you can go repayment-style mortgage. What does that mean? All mortgage products, all loans, fall into one of those two camps essentially, no matter how they're written up in the advertising literature. They're either interest-only or repayment. That's worth bearing in mind.

Interest-only is tempting. With interest-only you borrow, let's say £100,000, and you commit to just pay the bank the interest on the loan at whatever rate that happens to be – 4%, for argument's sake. So you're not paying back the £100,000. Now, how's that work? You've got to pay it back at some point.

The idea is you just write a cheque. You pay the bank the interest every month on the loan and then you set up another vehicle that will eventually pay off the capital, because you've got to still pay off the £100,000 as well as the interest. And that could be some sort of equity-based product. They used to be known as ‘endowment mortgages’.

Now, the upside to interest-only loans is that the payment every month to the bank is lower than it would be if you were paying them back interest and some of the original capital of £100,000. That's the upside. The downside is you've got to be pretty damn sure that whatever you're going to use to repay the capital after 20 or 25 years, for argument's sake, is enough to do the job. The problem a lot of people found or have found in the past is they set up these little investment funds on the side saying, "Well, after 20 years this will have grown, the FTSE 100 fund, to £100,000 or more, so I'll be able to clear my mortgage and have a party".

The problem is if the equity market plummets, your little savings vehicle isn't enough to repay the original loan. Then you've got a problem. So interest-only mortgages are attractive because the initial repayment to the bank will be relatively low, but you've got to have some way to pay off the capital that you've borrowed in the future.

The alternative is a repayment mortgage. As the name suggests, there, every month your repayment to the bank is interest on the loan, 4%, for argument's sake, plus a little bit of the original capital you borrowed. So the idea being that after 25 years, for example, you will have cleared all of the £100,000, if that's the amount you borrowed, that you owe the bank. Now, the downside to that one is you will find your monthly payments to the bank are a little bit higher because they include interest and some capital. Of course, the upside is you know, provided you keep your job and keep up the repayments, you will clear your mortgage after 20 or 25 years. No doubt about it because you are chipping away at the capital every month.

Some traps to watch out for

Now that means that normally I would recommend, if you can afford it, you do a repayment mortgage of some sort. But watch out. There are a couple of traps which I want to finish this video on. This is a beginner’s introductory guide. There are a few traps to watch out for with mortgages.

So decision tree so far is, how much do I want to borrow? How much do I need to borrow? How much of a deposit have I got versus the amount required to buy the property I'm after? That will affect the deal you can get from a bank. But then you need to decide on the amount you're borrowing. Am I going to go down the interest-only or the repayment-style route? And I've already highlighted a couple of criteria to think about when making that decision.

Now, let's say for a moment I've picked a repayment-style mortgage. There are one or two other things to look out for. Number one, when you're looking up mortgage rates, and you can look up on sites like Moneyfacts and Moneysupermarket and so on, you can look up these rates on a number of different sites. When you're looking up mortgage rates, just watch out because you might see a juicy low rate and think, "Aha, brilliant, 3%”. And you think, "Well, that's a really low interest rate, I'm having some of that". Watch out.

Number one, is there an arrangement fee on top? Some lenders, will charge you quite a meaty arrangement fee. We could be talking £1,000, £1,400, £2,000 just to set up the mortgage. All of a sudden that 3% is not looking quite so good. So you need to compare apples with pears. Is 3% with an arrangement fee the same as 5% with no arrangement fee? So there's one little trap to watch out for. Always check the arrangement fee.

Number two, watch out for low-ball initial deals. The ones where the bank says, "Come to us, borrow from us because what we can do is set you up for a few years on a really low rate". But then watch out because once that low rate period ends, you might be kicked into what's called the standard variable rate, SVR. And that may be, first of all, not a fixed rate, and secondly a lot higher.

Thirdly, redemption penalties. If you take out a deal and it commits you to a minimum number of repayments over a number of years, watch out that you're not stung if you need to switch product or kick out of there early. Because if something goes wrong, you may be stung for a big redemption penalty simply to get out of the mortgage early or move it or change it. So there's a few traps to watch out for when you're shopping around for a mortgage.

So just to recap there, a mortgage is a secured loan. The good news is that means you can borrow lower than you would on other types of loan. First decision to make, how much do I need to borrow? The less you need to borrow the better the deal you'll get. Third thing just to bear in mind is that you've got to make a decision between interest-only and repayment. You've also got to make a decision between paying a fixed rate and paying a variable rate of interest. Lots of things to think about here. Fixed rates, certainty. Variable rates, well, the opportunity may be for your mortgage payments to go down if interest rates fall as well as up if they rise. So you have another decision to make there. Do watch out for little stings in the tail, including arrangement fees, low initial rates to grab you in, and redemption penalties.

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  • playschool

    I think we know a song about that, don’t we children…

  • Tim

    Be great to know how it goes – my daughter doesn’t often sing about mortgages but each to their own I guess.

  • Really!

    Is this for real! Who is this aimed at? People leaving school can’t afford a mortgage, people who can actually get a mortgage should know these basic priciples, simple math really!

  • Tim

    Really. If people knew all the financial market basics we couldn’t have got into the mess we did a few years ago. Who is their right minds would have signed up for an endowment mortgage for example? Or who would take out a mortgage of 125% of the value of their property? We are a dnagerously under-educated nation when it comes to even the simplest financial concepts. For example I recently met an investment trust director who could not explain gearing to me – at all. Scary. So no apologies for covering the basics, though admittedly some people shouldn’t need them.

  • Peter

    @3. It’s maths with an “s” by the way!

  • House Price Crash

    Anyone who gets an “Interest Only” Mortgage are silly, especially now house price’s are finally falling and falling at there fastest pace believe it or not. Home owner’s havnt woke up yet they think they can’t fall anymore! I can assure you they will continue to fall for next couple of years at least as not many First Time Buyer’s are out there due to prices being too expensive, Bank’s not lending don’t help and also wait for it “DEPOSIT” needed which peopel cannot afford. More people leaving the UK so we look forward to weak Growth in the coming year’s. This is just the start of the house price crash and those who brought a house in the last 5 years are already in Negative Equity. Are you going to buy a house today knowing there going to be cheaper tomorrow?

  • Boris MacDonut

    #1 & #3. The average UK adult has a reading age of 11. Tim’s guide is aimed at beginner’s. It is a valuable tool Tim, well done.
    Worth mentioning don’t commit more than 30% of THP to mortgage payments unless you earn a very large salary. Also never agree to mortgage exit fees, they contravene the consumer regs.

  • Tim

    Boris – thanks and agree with your comments.

  • Orb

    I cannot fathom why some – who consider themselves financially competent – would want to watch this, then take the P. I know a pilot – supposedly a job that requires above-average maths capabilities – who doesn’t really know exactly how the world of finance works, let alone mortgages. In fact, I know of only one other individual who has a good understanding of finance, and yet still didn’t notice his wife bankrupting them! They have since been made insolvent.

    I also know a considerably wealthy, retired, qualified Barclays FA who isn’t able to piece together the inter-relationships between various financial aspects – scary!

  • Orb

    There is a VERY big difference between a maths academic and a financially savvy individual… how many of you out there are competently able to describe to another how credit card debt is designed to entrap you into becoming a debt slave?

    If I had my way, I’d FORCE a finance competence exam on anyone applying for debt in order to get it. Thanks Tim for your valuable contribution towards the education of Joe Public; we look forward to the next installation 🙂

  • Matt

    This is certainly aimed at beginners but it always amazes me how financially naive many people are and it is great to have guides like this to provide a starting point into the subject.

    Would you ever plan to follow up on this with a ‘mortgages advanced’ course Tim?

  • Fl3tch3rb0y

    Ha…reading some of the comments is quite funny…

    I actually, LIVE in the real world! You know, the one which is actually happening at the time you make ‘real time’ decisions lol…
    I took out one of those 125% mortgages with N Rock at the time. Why? because to sign up to private rental at the time would have cost me far more.
    It was down to basic cash flow. I’m currently on an interest only with just above 30% equity at a cost of less than £100 per month on a base rate tracker…

    Do I fell silly or naive that I took out this deal? ….absolutely not one bit…Was it an insane deal? well…only for the bank.

    My point really is that life is hard in the UK for the ordinary working man and often your not in a position to make what might necessarily be the ‘right decision’
    Most of the time finances are so hard that every financial decision is an insane one.