Applying & Obtaining a Mortgage in 2011
The decision to take on a mortgage is a big one and should not be taken lightly. It is likely that you will be repaying it for most of your working life. It’s extremely important therefore to make sure that you get the mortgage that is right for you. You should be prepared to pay a little extra for some good quality independent financial advice.
There are several different types of mortgage available and as well as choosing the right product from the right lender, you need to decide which type of mortgage is right for you. Repayment or interest only? Fixed or tracker? Do you go for a shorter or longer mortgage term? It can all be a little overwhelming but this article is intended to try and explain some of the many different terms used when finding a mortgage.
Choosing the Right Mortgage Repayment Method
The first thing to do is to decide which repayment type is right for you. There are three basic options, repayment, interest only and pension.
Repayment Mortgages
This is the most common type of mortgage. A lump sum is borrowed and is then paid back over a fixed term, say 25 years, with interest. Each monthly payment includes an element of interest and an element of capital, so each month the total outstanding debt reduces. Interest accrues monthly so the sooner you pay off the mortgage, the less interest you will pay overall.
The monthly payments will go up and down as interest rates fluctuate. At the start of the term most of your monthly payment will go towards interest so the debt will reduce very slowly. It will reduce more quickly the further into the term that you get.
At the end of the term the debt will be paid in full and your property will be free of mortgage.
Interest Only Mortgages
With an interest only mortgage, only the interest is paid each month. You do not repay any of the capital. This does mean that the monthly repayments will be lower but it is quite a short term option. Interest is calculated each month on the capital outstanding so as the capital never reduces, neither does the interest. With a repayment mortgage, as the total capital owed reduces so does the interest so with an interest only mortgage you end up paying more interest if you keep it for a full 25 year term.
Even though you do not have to pay back any of the capital each month, you do of course have to repay it at the end of the mortgage. This usually means selling your property. The idea is that by the end of the term your property is worth substantially more than what you originally paid for it, so you can sell, pay of the debt and still have a good profit.
An interest only mortgage tends to suit either investors, who buy a property and either renovate it and sell it on quickly or let it for a while using the rent to cover the mortgage until it increases in value and then sell, or people who find themselves in financial difficulty for example as a result of a temporary reduction in income.
Endowment Mortgages
Endowment mortgages, sometimes called pension mortgages, are basically interest only mortgage but with a pension plan attached. Part of the monthly payment pays the interest and the remainder, instead of paying off the capital as with a repayment mortgage, is invested just like a pension. The idea is that at the end of the term the pension or endowment will be worth enough to pay off the capital as well as leaving a lump sum payout for the homeowner.
Endowment mortgages are risky as has been seen in recent times where the final return has not been sufficient to repay homeowner’s mortgages, resulting in them having to either take on a new mortgage or sell their homes. As a result they are unpopular at present but no doubt they will make a comeback at some point in future.
Fixed or Standard Variable Rate Mortgages
The rate of interest you will pay on your mortgage depends on the Bank of England Base Lending Rate as it is from this rate that banks take their lead and set their own lending rates. It is possible to fix your interest rate for a set period or have it vary along with changes is the base rate.
Fixed Rate Mortgages
If you choose a fixed rate mortgage then, for the duration of the fixed rate period, your interest rate, and so your mortgage payments, will stay the same regardless of any changes to the base rate. This means that if the base rate increases you will be better off but if the base rate falls you will be worse off.
A fixed rate mortgage could be a good choice at the moment, with interest rates being as low as they are ever likely to get (the base rate is 0.5%) and likely to rise before too long. A fixed rate mortgage is also a good way to keep control of your finances if you are on a tight budget and if a sudden increase in mortgage payments would put you in difficulty. The trade off is that the rate you pay will be higher than the standard variable rate at the time you take your mortgage. The longer you fix your rate for, the higher it will be. So if you take a fixed rate deal now then in the next six months interest rates increase you will probably end up better off, however if they remain at the same level for the next 3 years you will lose out.
When a fixed rate mortgage beware that rates by increase quite significantly during the fixed rate period and while variable rate borrowers will experience this as a gradual increase over a period of months or years, you may experience a sharp shock as your rate switches from fixed to variable.
Variable Rate Mortgages
With a variable rate mortgage, the rate of interest you pay will fluctuate along with the base rate, so as interest rates rise so will your mortgage payments. As they fall, so will your payments. When you choose variable rate mortgage you are effectively gambling on rates staying low for the next few years (remember that with a fixed rate deal, you can usually only fix your rate for at most 5 years). If your gamble pays off you’ll pay less than you would on a fixed rate, if it does not then you will pay more.
Choosing the Right Mortgage Term
The term of the mortgage refers to the number of years over which you repay it. A longer term means lower monthly repayments but of course you will be paying it for longer. This means that ultimately you will pay more interest.
It is usually better to opt for the shortest term you can reasonably afford. Apart from being mortgage free quicker (and you’ll only really understand the benefit of this when you’ve had a mortgage), if you get into difficulty you can always remortgage to extend the term and reduce your monthly repayments. If you already have a 40 year mortgage it is unlikely you’ll be able to stretch it out over any longer.
If you have to start with a longer term initially, then keep in mind that as you become better off financially you can always remortgage to reduce your term in exchange for higher monthly payments.
Do You Know Your Credit Rating?
A poor credit rating will have an adverse affect on how much you can borrow and from whom and so it’s worth checking your score with a credit reference agency once you start thinking about buying your own home, even before you have saved for a deposit. Be sure to read our article – 10 Myths of Credit
If you have a low score there are things you can do to improve it. Register on the electoral roll if you haven’t already and make sure you pay any bills you have on time each month. If you don’t have a credit card then obtaining a basic one might help. Use it instead of cash, making sure you pay the balance in full every month so that you don’t incur any interest. Do not be tempted to run up a balance that you can’t repay each month however as this may actually damage your chances of obtaining a mortgage.
A better credit rating will give you access to better mortgage deals and can therefore have a very significant long term impact. It can be wise therefore to delay obtaining a mortgage until your rating is as good as it can be.
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