What Is a Mortgage and How Does It Work?

Elliot Hughes
May 8, 2024
10 Mins
Updated:
June 12, 2024

What Is a Mortgage and How Does It Work?

Contents

Intro & Overview 

This is the second installment of ‘The Buying Process’ series, following on from the overview of the buying process you can find here. 

As a reminder, the buying process consists of 3 steps:

  1. Establishing a Budget
  2. Finding a Property & The Mortgage Offer
  3. Conveyancing 

In this article, we look into the first major part of buying a property, establishing a budget.

The funding of a purchase has 3 main components.  

  • The Mortgage
    • A secured loan, usually from a bank or building society
    • Typically 75-90% of the purchase price
  • The Deposit 
    • Your funds that cover the shortfall between the mortgage and the purchase price.
    • The deposit size is linked to the mortgage size
    • Typically 10% of the purchase price for residential and 25% for buy to let.
  • Disbursements, Fees & Taxes
    • Funds to pay for conveyancing, surveys, searches and stamp duty. 

Let’s look at what a mortgage is and its link to the deposit.

The Mortgage 

What is a mortgage?

A mortgage is a type of loan. 

Mortgages are secured loans. This means the lender will take a charge over an asset you own; in case you are unable to pay back the loan. The asset is a form of security for the lender. The most common security for a mortgage is a property.

What is a Mortgage Term?

This is the length of time you take a mortgage for. 

Mortgages are usually taken for a term of 20 to 40 years, the most common being a term of 25 years 

What is a Mortgage Broker?

This is a qualified professional that acts as an intermediary between you and a mortgage provider (lender).

You can submit your information to them, and they will help you find the best deal to suit your circumstance. 

A good broker will also be on hand to help guide you through your property purchase.

What is a Decision in Principle?

Also known as an agreement or mortgage in principle.

An indicative maximum loan amount based on a brief snapshot of your financial situation, known as a soft credit check.

Having this in place prior to viewing properties can provide estate agents and sellers more confidence that you’re a serious buyer.

What is Loan-to-Value (LTV)?

Mortgages are expressed as a Loan to Value (LTV). 

This is the size of the loan in relation to the value of the property. 

For example, a loan of £80,000 on a property valued at £100,000 would be at 80% LTV because the loan makes up 80% of the total value. 

The LTV and the deposit are directly linked, as they always add up to 100%. This means a higher LTV mortgage needs a smaller deposit, and vice versa. 

What is a Mortgage Product?

This is the deal a borrower selects for a period of time. It could be fixed, variable or discounted and typically lasts 2 - 5 years.

  • Standard Variable Rate
    • Every lender has a standard variable rate.
    • This is the rate that a mortgage will be charged at when the borrower has not chosen a mortgage product, or their chosen product has ended.
  • Fixed Rate
    • A mortgage product with a fixed interest rate for a set period of time
  • Variable Rate
    • A mortgage product with an interest rate that can change. It can go up or down.
    • You may choose this if you think rates are likely to decrease.
  • Tracker Rate 
    • A type of variable rate that is linked to the Bank of England (BoE) Base Rate.
    • Usually a set percentage above the BoE rate.
  • Discounted Rate
    • A mortgage product with a set discount below the lender’s standard variable rate for a fixed period of time, EG 3% discount on SVR for 3 years

How do I get a mortgage?

When looking for a mortgage, you can do this using online tools, or you can speak to a mortgage broker. Regardless of method, you should obtain a decision in principle, allowing you to understand the theoretical maximum loan you could achieve. 

For business owners and those that are self-employed, we’d always advise you to speak to a broker as there’s more nuance to the figures you can use as your income.

Mortgages are expressed as a Loan to Value (LTV). Buy to Let mortgages are typically capped at 75% LTV, while residential mortgages typically allow up to 95%, with some lenders even reaching 99% LTV. 

At 99%, that would mean you’d only need a 1% deposit to make up the difference.

Does Loan to Value (LTV) Make a Difference?

LTV can have a big effect on the rate you pay on your mortgage.

As the LTV goes down, the risk taken on by the lender decreases as there is more of the owner’s equity in the property.This is the value of the property minus any loans against it. 

As the risk reduces for the lender, they can afford to charge less interest to the borrower.

Each lender will offer multiple products, with different rates, fees and terms. Each product has a maximum LTV, with the interest rate generally decreasing as the LTV decreases. 

Alessia and Her Purchase

Alessia is looking to buy a house for £100,000.

She has £17,000 available but had planned to use a deposit of £14,000 and keep some savings.

Her £14,000 deposit would need a mortgage with an LTV of 86%. 

Lender Bank has a suitable product, offering a rate of 5.15% with a maximum LTV of 90%. Alessia is within the max LTV, all good. 

Lender Bank also has another product, with a rate of 4.95% capped at 85% LTV. 

Alessia could add £1,001 to her deposit, bringing her down to 84.99% LTV. 

As this is below 85% LTV, she can use the lower rate product, saving 0.25%. 

You should always check the thresholds for any mortgage products you’re looking at, as adding  a bit more cash to the deposit may reduce your rate. 

Mortgages Types & Uses

Mortgages are usually taken for one of two purposes:

  • Residential - Buying a property to live in (Owner Occupier) 
  • Buy to Let - Buying a property as an investment (Investor)

Each purpose has a strong correlation to a different type of mortgage. 

  • Repayment Mortgages - Typically used by Owner Occupiers
  • Interest Only Mortgages - Typically used by Investors

Repayment Mortgages.

This type of mortgage is typically used by Owner Occupiers – people buying a property to live in it.

How repayment mortgages work

As the name suggests, repayment mortgages are designed to repay the loan over its term. 

By the end of the mortgage term, assuming no payments have been missed, the loan will be paid off.

The monthly payments consist of 2 elements:

  • Interest on the outstanding loan balance
  • A sum to reduce the capital owed

The balance of the interest and capital change over time, with earlier payments made up largely of interest and a small portion of capital. Over time this balance swings, with later payments made up predominantly of capital. This is called front-loading interest, which you can see in the graph below. 

Here, we assume you have a £250,000 mortgage over 25 years. The payments per year are £17,738, but the composition of them changes over time.

Breakdown of Repayment Mortgage Payments

As there are payments being made towards the balance each year, the balance reduces throughout the mortgage term, with the mortgage paid off by the end of the term.

Repayment Mortgage Balance Over Term

How much can I borrow with a repayment mortgage?

Lenders use different means to work out the maximum loan size depending on how you’re paid.

Salaried Workers Buying a Home 

Borrowers can broadly expect to receive 4 to 5 times their annual salary with an LTV of up to 90%. There are lenders that allow for higher borrowing multiples or higher LTVs, too. Such products are offered with an increased interest rate to offset the increased risk. 

In some instances, the career path you’re on can also help convince lenders to stretch their affordability criteria. Those in high growth industries, or in jobs with set progression, such as grad schemes and medical training, could be able to borrow against expected future income. 

Self Employed & Entrepreneurs Buying a Home 

The lending criteria for self-employed is different. Any business owner that owns more than 20% of their company is likely to be classified as self-employed by lenders. 

Rather than taking your declared salary, if you have one, lenders look at your previous years’ accounts to determine your net profit. They will look at the average of 2 or 3 accounts to establish the income they can use for their affordability calculations.

Interest Only Mortgages

These are chiefly used by investors taking out buy to let mortgages. Below, we speak about interest only mortgages for buy to let customers. 

How interest only mortgages work

The sum borrowed remains constant throughout the mortgage term, with the borrower only paying interest. At the end of the term, you will still owe the full mortgage balance unless you’ve made any additional payments. At the end of the mortgage term, you will need to repay the loan using your own funds, or with another mortgage.  

Interest Only Mortgage Balance Over Time

Rates for interest only mortgages

Rates for buy to let mortgages can be anywhere from 2-5% higher than those offered to owner occupiers. This is a key driver behind many landlords opting for interest only, as it allows them to keep monthly payments down, giving them a positive cashflow.

How much can I borrow with an interest only mortgage?

Lenders typically offer up to 75% LTV for buy to let investors, meaning the deposit needed is far chunkier (often 25%+ of the property’s value).

The size of the loan is contingent on the rent the property can achieve. 

Banks apply an income cover ratio of 25% or 45% to the rent to ensure that the rent can cover the mortgage after tax. 

For any product running for less than 5 years, they will also apply a stressed interest rate to ensure the property’s income would be sufficient to cover the mortgage payments should the rates increase at renewal.

The Deposit

What is a deposit?

In its simplest terms, this is the money you have saved up or obtained to put toward a property purchase. It makes up the difference between the total purchase price and the mortgage advance. 

The source of the funds will need to be verified by the lender, often via a solicitor, to ensure they have not been obtained through illegal means. 

When buying a property to live in, a typical deposit will be at least 5%. 

For buy to let investors, far more cash is needed, with deposits usually starting at 25%.

Balance of Mortgage and Deposit for House Purchase England

Often, this will be the result of years of savings and investments, being pooled together to go towards the property purchase. There can be other sources, too.

Gifted Deposits

Someone can give you money towards your property purchase. This would usually be a relative or a friend, but could theoretically be anyone. 

A gifted deposit must be a gift.This means there cannot be an intention or expectation for the funds to be paid back.

Both the person gifting the money and the receiver of the gift must sign a document to confirm that the cash is a gift and there is no expectation of repayment. The gifter cannot be granted any portion of the property purchased. 

These can often be used by parents or relatives trying to help their children or family boost their spending power. 

The source of the funds will need to be verified in the same way.

Summary

If you aren’t purchasing your property outright with cash, mortgages are vital and they often make up 75-90% of the purchase price.

The deposit and mortgage are inversely related, meaning as one goes up, the other decreases, as they always total 100%. 

Overall, mortgages for investors and owner occupiers share a lot of the same characteristics. 

Both mortgages will have an LTV limit, with owner occupiers being afforded a higher one. 

The size of the loan is governed by income in both cases, with owner occupiers personal income determining their maximum loan, and rent determining the maximum loan of a buy to let mortgage.

The main difference is what happens to the loan balance. 

As most owner occupiers favour repayment mortgages, their loan will be paid off by the end of their term. Buy to let investors tend to opt for interest only mortgages to help keep running costs down, but this means they will need a find to repay their mortgage at the end of the term. 

Regarding deposits, producing a larger deposit can usually give you access to a larger range and more favourable rates, so if you have some money hiding in the sofa, be sure to pull it out!

Catch us next time for our run-down on the costs associated with a property purchase.

If you have any questions, please do get in touch with us today

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