What is a mortgage?
By Jenny McCall
Reviewed by Vanessa Kintu
A mortgage is a type of loan that helps buyers to purchase a home. Mortgage loans are either used to buy a home, or borrow money against the value of a home you already own.
Mortgages are one of the most expensive financial products people ever take out. As a result it is important to understand the terms of a mortgage to pick the right one for you. Since a mortgage is secured against a property, if you fail to keep up with mortgage repayments, your lender could repossess your property.
Key takeaways
The definition of a mortgage is a secured loan, with a piece of real estate such as a home or farm acting as the security.
The lender can take possession in the event of a default, but must surrender any rights over the property once the loan has been repaid.
There are a number of different types of mortgages, including fixed-rate mortgages and adjustable-rate mortgages.
How mortgages work
There are many different types of mortgages. The first is a fixed-rate mortgage, where the interest rate on the mortgage remains the same for the duration of the deal. Some borrowers have two-year deals, or longer. The length of the deal is normally dependent on the products the bank or financial institution offers.
If the deal is two years, then your interest rate remains the same whether or not the central bank raises rates during that time. Below is a list of other mortgage types:
Adjustable-Rate Mortgages (ARM)
Also known as a variable rate mortgage, ARMs are the opposite of fixed rate mortgages. The rate changes during the life of the loan based on movements in the market. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, but the rate rises over time and can eventually overtake the rate of a fixed-rate loan.
Tracker mortgages
These mortgages track a nominated interest rate, which tends to be the central bank base rate, for a period of time. When the base rate rises, the mortgage will rise by the same amount, if the base rate falls, the mortgage rate also falls.
Discounted rate mortgages
These types of mortgages offer a reduction from the lender's Standard Variable Rate (SVR) for a certain time period, which tends to be between two to five years.
Capped rate mortgages
Similar to variable-rate mortgages, capped rates can rise and fall over time, but the difference is there is a limit above which your interest rate can not rise, this is known as the cap. It can provide reassurance that your repayments will not exceed a certain amount, but still benefit from rate declining.
Government-backed mortgages
There are many types of these mortgages:
Shared ownership is for first-time buyers in the UK and helps get them on to the property ladder. The buyer will purchase a share of the property, typically between 10% to 75%. The remaining shares are owned by the local housing association or developer who built the property.
Help to buy ISAs is no longer open to new customers, but was designed to help first time buyers in the UK save for a mortgage deposit.
The mortgage guarantee scheme offers lenders the option to purchase a guarantee on mortgages, where the borrower has a deposit of only 5%. The guarantee compensated lenders for a portion of net losses, should the home be repossessed. This scheme is also no longer available to new customers in the UK.
To understand mortgages, it is important to know the basics of mortgages and the different types of mortgage terms.
Principle. Refers to the amount you borrow from your lender to buy your home. The principle is the most substantial part of the mortgage, the interest should be the lesser part.
Interest. The money you pay the lender for borrowing from them. The borrower pays a percentage of the amount borrowed, this is known as the interest rate. The lower the rate, the less you’ll have to pay to the lender in borrowing costs.
Amortisation. This refers to the home loan pay off process. The lender will create a payment schedule when you first take out a mortgage. So the amortisation period is the length of time it takes to pay off a mortgage in full.
Qualifying for a mortgage
In qualifying for a mortgage you need to look at several things. The first is your credit score.
Credit score
Most lenders consider credit score when determining whether to approve a mortgage application and what interest rate to offer. It tends to be, the higher the credit score, the lower the interest rate and less borrowing costs.
Income and employment history
Lenders want to ensure the borrower has a steady and reliable source of income to make their mortgage payments. Lenders may require at least three months of payslips and a three month bank statement.
Debt-to-income ratio (DTI)
DTI is a measure of a borrower’s monthly debt payments divided by their gross monthly income. So, if the borrower has a monthly income of £6,000 and makes monthly debt payments of £1,000, their DTI would be 16.6% (£1,000/£6,000).
Down payment and closing costs
The down payment or deposit refers to the portion of the purchase price that the borrower will pay upfront. It can range between 5% to 20% of the home’s purchase price. This can also affect the interest rate and the mortgage payment, a larger deposit can reduce the monthly mortgage payment and possibly the interest rate.
The closing cost refers to the fees associated with finalising the mortgage and transferring ownership of the property. These will be a combination of legal fees, appraisal fees and other charges.
The mortgage process
Pre-approval. Also known as getting a mortgage in principle. This is when the borrower assesses your creditworthiness and determines the maximum loan amount you qualify for, based on income, debt and credit score. It gives the borrower an idea of how much they have to spend on home.
Property search. The borrower will then have to start looking for a property using estate agents and other sources, such as property developers.
Loan application. Once the borrower has found a property they like, they will then complete the loan application or apple for a mortgage.
Underwriting. This is the process the lender will use to evaluate the borrower’s application and see if they are eligible for a mortgage. At this stage the lender will go through the borrowers home, employment history, credit score and DTI to assess creditworthiness. The borrower must then wait for the mortgage valuation and then to receive their offer.
Closing. The closing stage then takes place and the borrower will enlist a solicitor or legal representative to carry out all of the legal formalities. Once this is all complete, the legal team will agree when contracts are exchanged – it’s at this point that the home officially and legally becomes the property of the borrower. The final stage is completion and that is when the borrower can move into their new home.
Managing your mortgage. Once you are moved in you must make timely repayments to your mortgage or your home will be repossessed. Part of this process involves understanding the terms of your mortgage Below are some other things to consider.
Refinancing. If your product comes to an end you will have to look at refinancing and may get a better deal if interest rates have dropped but also may have to pay more if interest rates have risen. Communicate with your lender, especially if you're facing financial difficulties.
Paying off your mortgage. You can make additional payments each month if you need to, this can reduce the mortgage amount. You are also able to pay off your mortgage in full if you have the finances available.
Dealing with financial hardships. Communicate with your lender, especially when experiencing financial difficulties. Your home can be repossessed if you do not keep up with the payments.
Conclusion
A mortgage is a type of loan that helps buyers purchase a home. Mortgage loans are either used to buy a home, or to borrow money against the value of a home you already own.
Mortgages are important to understand, as it is one of the most expensive financial products people ever take out. It is also important to understand the terms of a mortgage and pick the right one for you. Since a mortgage is secured against the property, if you fail to keep up with your mortgage repayments, your lender may and can repossess your home.
FAQs
What are the different types of mortgages?
The first is a fixed-rate mortgage, where the interest rate remains the same for the duration of your deal. An adjustable-rate mortgage is the opposite of a fixed rate. The rate changes during the life of the loan based on movements in the market.
Tracker mortgages track a nominated interest rate, usually the central bank base rate. Discounted rate mortgages offer a reduction from the lender’s Standard Variable Rate (SVR) for a certain time period, which tends to be between two to five years.
Capped rate mortgages are similar to variable rate mortgages, capped rates can rise and fall over time, but there is a limit above which your interest rate can not rise, this is known as the cap.
What is the difference between a mortgage and a home loan?
A mortgage is a loan used to purchase a property, the property is used as collateral for the loan. A home loan is a broader term that can refer to finance used to renovate a home.
What is the mortgage process, and how long does it take?
The mortgage process can take between two to eight months, but this is dependent on the borrower's personal circumstances, it may take longer or less time.
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