What is a Mortgage?By Money Mage · · Mortgage, Frugality
A mortgage is a loan taken out to buy property or land.
Most mortgages are long term loans, usually 25 years, but the length can vary. The length of a mortgage is called the term.
The mortgage is ‘secured’ against the property or land bought. If you fail to meet repayments your property could be repossessed. If this happens the lender would take back the property and sell it to repay the loan.
The lender charges you interest on the outstanding balance of the loan. This is called the mortgage interest rate or rate. This is the lender’s fee for providing the loan.
For the majority, the only way of buying a property is with a mortgage.
What are the different types of mortgage?
There are a bewildering array of mortgages. Repayment, interest-only, variable, tracker, discount, offset.
It’s Jargon hell and puts off many.
There are Types of mortgage, and there are mortgage Rates.
There are two major Types of mortgage: Repayment and Interest Only. There are two major mortgage Rates: Fixed Rate and Variable Rate.
|Repayment Mortgage||Interest Only Morgage|
It’s possible to have a Variable Rate Interest Only mortgage. It’s also possible to have a Fixed Rate Repayment mortgage.
Generally speaking, a Money Mage would want to go with a repayment mortgage. There are some reasons for Interest Only but they are niche. Property investors are the main customers of Interest Only mortgages.
So what are the different Types?
With a repayment mortgage, you are paying back part of the loan amount and interest every month. At the end of the term, you owe nothing.
- You pay less interest over the term, as your loan amount reduces over time.
- You repay your loan so when it comes to remortgaging or selling you own more of the property.
With an interest only mortgage, you are paying back part of the interest every month. At the end of the term, you owe the full loan amount. You need to prove you can pay the loan off at the end of the term.
- Lower monthly repayment
- Managing finances to repay large a loan at the end of term
- Pay more interest as loan amount never reduces
- Harder to get. Need to provide evidence of repayment ability at the end of term
What are mortgage Rates?
The biggest choice is what kind of mortgage rate. This is a choice between Fixed Rate or Variable Rate. If you go the Variable Rate route, there are different kinds of Variable Rate mortgages to be aware of.
A fixed rate mortgage is a mortgage that has a fixed rate of interest for a fixed time, usually between 1 and 10 years.
Fixed rate mortgages are the most straightforward to understand. You’ll have a fixed amount to pay every month for the length of the deal period. The deal period is not the same as the mortgage term.
- Simple, fixed monthly repayment for the deal period
- Your repayment will not increase if central bank interest rates increase
- If central bank interest rates decrease, your repayment will remain the same
- Rates are usually higher than Variable Rate products
A variable rate mortgage is a mortgage that has a variable rate of interest. This means the amount you repay every month may change.
There are different types of variable rate mortgages. Standard Variable Rate, Tracker, or Discount Rate
Standard Variable Rate
A standard variable rate mortgage does not have a period, it’s the lender’s standard rate. The lender changes this as they see fit. The rate is often higher than other deals. Usually, you revert to the Standard Variable Rate after the end of any mortgage deal period.
- Often no product fee
- Often no early repayment charges
- Good if you want to pay off your remaining balance
- At mercy of lender to change rate
- Not guaranteed that drop in base rate will reduce your interest rate.
- Rate is often higher than Fixed, Tracker or Discount
Most people are not Standard Variable Rate mortgages. They often have the highest rates. Yet, It can make sense to stay on a Standard Variable Rate in some situations. They often have no associated product fees, and often have no early repayment charges. This can be useful if you are wanting to pay off the outstanding balance. If you are selling your home, or have come into some inheritance and want to pay off your mortgage.
A tracker mortgage provides a rate over and above the central bank interest rate (‘base rate’). A tracker mortgage lasts for a fixed time, usually between 1 and 10 years. For example, a tracker deal might be +1% above ‘base rate’ for 2 years. If the base rate is 0.75% your rate would be 1.75%, but if the base rate increases to 1%, your rate would increase to 2%.
Tracker mortgages are usually one of the cheapest. In the current market, you have the added risk of interest rate increases. Rates are historically low so they only have one way to go. The amount you repay every month can vary.
- Transparency of rate increases, changes when central bank base rate changes.
- Often a cheap mortgage
- Uncertainty on monthly repayments, if rates rise, your repayments change
- Locked in for a period, so if rates rise, you will have to pay.
A discount rate mortgage provides a rate below the lender’s standard variable rate. For example, if the standard variable rate is 5%, and the discount is 2%, your rate would be 3%. Check your lender’s terms.
Discount mortgages are usually one of the cheapest. The amount you repay every month can vary.
- Often one of the cheapest mortgages
- Uncertainty on monthly repayments, if the standard rates change, your repayments change
- Locked in for a period, so if rates rise, you will have to pay.
At the end of any deal period, you will likely revert to the lenders Standard Variable Rate. You can often switch to another mortgage with the lender at the end of the period.
What deal length should I choose?
Most mortgages today have a deal length. An initial ‘deal’ period where your rate is low. Deal length is different from Term. Deal length is like the ‘introductory offer period’ and is generally 1 to 10 years. The Term is the entire length of the mortgage, usually 25 years, but can vary also.
When the deal period ends, you often revert to the lender’s Standard Variable Rate. The Rate you revert do after the Deal ends is is often much higher than the Deal Rate.
For example, a Nationwide 2 Year Tracker at the Base rate +1.24% will be 1.99% (at 0.75% base rate). For two years. Then it will revert to Nationwide’s Standard Variable Rate at the end of the two years (4.24% Aug 2019). This shows you the difference between Deal and Standard rate - 1.99% compared to 4.24%!
You can move to a new deal at the end of the term, but sometimes product fees apply.
Deal lengths can vary, often between 1 and 10 years. So why not go with the longest deal length possible?
Unfortunately, it’s not that simple.
Often deal periods come with penalties, especially Early Repayment Charges. These can be very high in the first few years of a new mortgage. Nationwide’s 5 Year Fixed at 2.19% has a 5% Early Repayment Charge in the first year. Nationwide’s 10 Year Fixed have 7% Early Repayment Charges until Year 5! Choosing the right Deal Length is about weighing the risks.
Longer term Fixed Rate deals tend to have a higher rate, as the lender is taking the risk that rates change. Shorter Variable Rate deals tend to have the lowest rate. As more of the risk is with you.
There is no right answer to this. The choice depends upon your circumstances and appetite for risk:
- What is the likelihood I will need to sell the property during the deal period?
- What is the likelihood that interest rates will change during the period?
Fixed Rate mortgages are a bit like an insurance policy against base rate increases. But if rates drop you don’t benefit.
If in doubt you can take advice.
Are there fees when switching deal?
The lowest rate mortgages often come with a product fee. This is a fee the lender charges you when you take the mortgage out. These can vary but can be over £1,000.
When your Deal period ends, be aware of how much the product fee is going to save you.
Take two Nationwide 5 Year Fixed mortgages:
- 2.14% with no fee
- 1.94% with a £999 fee
0.2% difference in rate needs to save you more than £999 in interest over 5 years to be worth the product fee.
Consider a £180,000 mortgage:
|5Y Payments||5Y Interest|
|2.14% no fee||£46,515.60||£18,068.02|
|1.94% £999 fee||£45,461.40||£16,352.19|
What does £999 get you over 5 years on a £180,000 mortgage:
- £1,054.20 in your pocket due to lower monthly repayments.
- £1,715.83 less interest paid to the lender.
In this case, £999 is worth it.
For a smaller mortgage or a shorter term, the numbers might not work out! Be careful about paying product fees. You will have to do the calculations for your situation. It may work out cheaper to go with the no-fee mortgage.
What are mortgage features?
Some mortgages come with features you may not be aware of.
Early Repayment Charges
Early Repayment Charges are charges due to the lender if you pay some or all of your mortgage off during your mortgage Deal.
Early Repayment Charges often are hefty at the start of your deal length, and decrease over time.
Imagine you have a £180,000 5 Year Fixed but your job demands you move to a new city in the first year. You have to sell your home. You’ll have to repay the loan amount to Nationwide. In the first year of a 5 Year Fixed at Nationwide, the Early Repayment Charge is 5% - or £9,000!
A hefty charge, and one to avoid. Be wary and check your Early Repayment Charge clauses.
Some mortgages permit you to overpay your mortgage. Overpaying your mortgage can save you tens of thousands of pounds in interest.
Overpaying is a great way of reducing this long term burden on your finances.
The blue line shows mortgage interest over term if you overpay double every month. You can pay off a £130,000 25-year mortgage 14 years early. Saving £23,454 in interest.
Be careful when overpaying you could be hit with Early Repayment Charges! Check with your lender, and check the terms of your mortgage. Some mortgage companies permit overpayments. For example, 10% of the loan amount per year without charges.
Payment Holiday What if you are struggling with repayments? Are you on maternity leave? Suffering from ill health? Been made redundant? You may be able to arrange a Payment Holiday with your lender.
Your lender may permit you to reduce or pause your monthly payments.
Remember when you stop paying, you are still incurring interest on your loan. This can be a costly option.
If you have overpaid your mortgage payments may come from your Overpayment Reserve. Talk to your lender first, don’t stop paying! If you are struggling, speak to your lender, and if that fails, speak to Citizens Advice.
So you have heard you can overpay your mortgage. If your mortgage has an Overpayment feature, it is likely you can build an Overpayment Reserve. This is the amount you have overpaid to date.
Overpayment Reserves can sometimes be used to take a paid Payment Holiday. When you stop paying, your payments come from your reserve. You will have to check with your lender to arrange first, don’t stop paying!
Some mortgage lenders provide an Offset facility. Offsets work like an Overpayment. Rather than Overpaying, you hold your savings account with the same lender.
Imagine you have a mortgage of £180,000 and savings of £15,000. Your savings of £15,000 ‘Offset’ your mortgage loan, reduced to £165,000. This reduces the interest charged.
You don’t earn interest on your savings you use to offset.
Some mortgage providers offer Cashback when taking out a mortgage. This is usually low hundreds of pounds but can be over £1,000 or 1% of the mortgage.
As with mortgage fees, you will need to do the calculations to see if this cashback is a saving. Is the Cashback wiped out by a higher rate or higher product fee?
What is the cheapest mortgage?
There is no simple answer to this, and you will have to shop around and do the calculations.
Mortgages are often about weighing the risks. Product flexibility, and short term liquidity compared to longer-term wealth.
Base rates are at an all-time low, which makes short-term Tracker products attractive. But base rates only have one way to go.
Short-term Fixed Rate products offer the peace of mind of a fixed monthly repayment. You pay a slight premium on your rate for the privilege. Often you face hefty Early Repayment Charges if you have to sell or repay early in the deal.
If you don’t want to spend the time shopping around you can pay an advisor or broker to shop around for you.
Find the best mortgage deals
If you are wanting to find a mortgage deal yourself, start online at price comparison sites.
This will give you an idea of the market at the time. You can check the main lenders, major banks and building societies. They often provide rough quotes and even offers in principle online.
It’s possible to take out a mortgage with information only. You don’t need to take advice or use a broker. But, if you are unsure about anything or concerned you may find it better to take advice or use a broker. You may have to pay a broker’s fee.
Are mortgages affordable?
Fruggles take out unaffordable mortgages. Fruggles live beyond their means. With a PCP Audi, 3 overseas holidays a year, and a new build 4 bed with a double garage. Then they lose their jobs and can’t make repayments.
Money Mages live within their means. A Money Mage wouldn’t have a PCP Audi but saves money when driving. A Money Mage wouldn’t be taking 3 overseas holidays a year but looks for cheap breaks. A Money Mage wouldn’t stretch their finances to buy a bigger property than their budget allows. A Money Mage is Mortgage Free at 35
As an aspiring Money Mage, you can find an affordable mortgage with a few simple tricks:
- How much you are spending on rental as a percentage of your income? Imagine having a mortgage with lower repayments. Let’s say your rent is £650/mo, so let’s go with £600/mo mortgage.
- £600/mo over 25 years will get you a mortgage of ~£140,000 at 2.14%
- What kind of property you’d like to live in?
- Where would you like to live? What location? What neighbourhood?
- Find out the price of properties you like, in the area you like. Let’s say it’s £260,000
The price of the property you’d like to live in (£260K) is greater than your budget (£140K over 25 years) by a fair margin - £120K!
This is a problem everyone buying a property faces. There are a few simple choices:
- Target a cheaper location
- Target a smaller property
- Target a similar property but one needing renovation
- Save a larger deposit
A mix of the four above is the magic of the Money Mage.
Nonsense I hear you scream. This can work even in costly locations. Consider a 1 bed flat East India Dock, London, overlooking the O2. £1,600pcm rental. A £1,500pcm mortgage will get you a £350K mortgage. The property is valued at £400K so you’d need a 12.5% deposit - close to the minimum deposit anyway!
The issue is how to save £50K when you have £1,600pcm going out on rent!
Whatever you do, don’t go all Fruggle and blow your budget. There are plenty of ways to be frugal and on the path not just to a mortgage, but mortgage freedom and early retirement.
Saving a large deposit
A Money Mage trick to buying a property is to save a large deposit. By being frugal you can save a healthy deposit.
There are no magic tricks when it comes to saving. You need to reduce your monthly outgoings. Place everything you don’t spend into the best paying savings & investment account. Do this over the years and your interest compounds.
A large deposit provides some benefits:
- You will have a better Loan To Value ratio, often meaning your repayments are lower
- You own more of your property
- You can afford a larger property
In costly cities, aggressive saving is the only way to grow a required deposit.
Loan to Value
Loan to Value or LTV is the ratio of the lender’s loan to the sale price, take the following example:
Sale Price: £260,000 Mortgage: £180,000 Deposit: £80,000
Loan To Value (LTV) : 180/260 = 0.6923 = 69.23%
Your Loan To Value effects your mortgage interest rate. A time of writing Nationwide 2 Year Fixed offer the following rates depending on your LTV: 90% LTV = 2.29% 80% LTV = 2.14% 50% LTV = 1.99%
Do be aware if you do this your money is tied up in your property. You’d need to sell or remortgage if you need that money for some reason. This is called liquidity.
Should I buy or should I rent?
The decision to rent or buy is highly personal. It will depend upon:
- Where you live and your cost of living
- What your income is
- Is your income stable and can you prove this to the lender
- What kind of property would you like to live in
- What are property prices like in the area
- Are you prepared to take on the costs of homeownership
- Do you have enough money to pay a deposit
- Can you afford the mortgage repayments
Paying rent is money out of your pocket and into your landlords pocket. Paying a mortgage is building your wealth. Money Mages know it’s better to build your wealth. The best way to gain wealth is to free yourself from the rental system of control. Stop renting as soon as you can afford.
Some say ‘Paying off mortgage interest is the same as paying the rent’. Yes, you will pay mortgage interest. Mortgage interest is tiny in comparison to rent.
The blue line is interest on a £130,000 mortgage over 25 years at 2.24%. Compared to an equal monthly outgoing rental of £566/mo over 25 years.
Lose £40K or £210K?
Free yourself from the rental system of control.
If you think you can’t afford to buy, try the following over the next year:
- Get some demonstrable stable income
- Get and maintain a good credit rating
- Watch your pennies, and save as large a deposit as possible
- Choose an affordable property as your first
- There are no affordable properties where you live! Are you living in the right area for your income bracket?
Whatever you decide - it pays to increase your knowledge of basic finances. Become more frugal, start saving, and shake off that Fruggleness. You’ll be a Money Mage and Mortgage Free in no time. Be sure to Subscribe for more.
The base interest rate set by a nation state’s Central Bank, the rate at which the Central Bank will lend to other banks. Used as a benchmark for interest rates.
A nation state’s national bank. Provides financial and banking services for government and the nations commercial banks. Also informs the government’s monetary policy and issues currency. I.e. the Bank of England, or US Federal Reserve
A legal document specifying evidence of ownership, especially related to property.
The length of your mortgage ‘deal’. Mortgages often come with a deal period, i.e. 4 year fixed rate mortgage has a Deal Length of 4 years. The Deal Length is not the same as the mortgage Term.
The amount of money you must put down to take out a mortgage. I.e. a deposit of £40,000 on a £400,000 mortgage is a 10% deposit.
Early Repayment Charge (ERC)
A charge your lender will charge you if you pay back your mortgage early.
The percentage of the property that you wholly own. Your property is worth £400,000. Your outstanding mortgage balance is £300,000. You own 25% equity in your property.
The ease in which assets can be converted into cash. An instant access cash savings account is highly liquid. An asset that cannot be easily converted into cash is illiquid.
Concerning a mortgage, the outstanding balance of the mortgage. The amount you owe to the lender.
Loan To Value (LTV)
The Loan to Value ratio is the ratio between the loan amount and the value of the property. If you take out a £300,000 mortgage against a £400,000 property, the LTV is 300K/400K = 0.75 = 75%
Rate (or Interest Rate)
The Interest Rate of the mortgage. The percentage you will be charged for, often measured annually but charged daily. If you take out a £100,000 mortgage and your mortgage Interest Rate is 2.14%, the interest per annum will be 100K * 0.0214 = £2,140
A legal process whereby the mortgage lender takes ownership of your property in the event of non-payment of your loan. This is possible as the mortgage lender holds a Security on your Title Deeds.
A mortgage lender holds security on your properties Title Deed, indicating that they own part of your property.
The length of your mortgage, usually 25 years, but can be as long as 35 years.
Sources and Attribution
- Low Interest Rates (c) LendingMemo, CC-BY
- Money (c) Petras Gagilas, CC-BY
- Time (c) Laurence Edmondson, CC-BY-ND