Buying a house is probably the most popular financial goal for many young adults. Unfortunately, houses in the West have grown so much in value over the past few decades it is almost impossible to buy a house in cash. That is where mortgages come in to provide the necessary financing for such large purchase. But mortgages are stressful, long and to many people, complicated. That is why we put together the complete mortgage guide, to deconstruct these products and breakdown everything you need to know before you start applying for one.
What Is A Mortgage?
A mortgage is a loan used to purchase a piece of real estate. The loan is secured by the property, which means that if the borrower defaults on the loan, the lender can foreclose on the property and sell it in order to recoup the money that they lent. The borrower makes regular payments to the lender, which can include both principal and interest or interest-only payments. The principal is the amount of the loan, and the interest is a percentage of the principal that the lender charges for borrowing the money.
Key Mortgage Terms
The following mortgage terms are key to understanding this mortgage guide. We recommend also reviewing our glossary of key financial terms.
- Loan amount: This is the total amount of money that you borrow from the lender.
- Interest rate: This is the percentage of the loan amount that you will pay in interest. A higher interest rate means that you will pay more in total over the life of the loan.
- Term: This is the length of time that you have to repay the loan. A longer term means that you will have lower monthly payments, but you will pay more in total over the life of the loan because of the interest that accrues.
- Type of mortgage: There are several types of mortgages, including fixed-rate mortgages and adjustable-rate mortgages.
- Down payment/Deposit: This is the amount of money that you pay upfront when you take out the loan. A larger down payment can result in a lower loan amount and lower monthly payments.
Loan Amount and Loan-To-Value (LTV)
As defined earlier, the loan amount is, quite simply, the amount borrowed from the lender. The Loan-To-Value, or LTV for short, is derived from the loan amount and the value of the property. It is defined as the ratio of the loan amount to the value of the property and calculated as follows:
LTV = Loan Amount ÷ Value of Property
The loan amount is an important factor when applying for a mortgage because it cannot exceed 4.5x times the annual gross salary (before taxes) of the applicants in the UK. Although some lenders can lend up to 7x the salary for certain professions. This means that the size and price of the property you can buy is partly driven by the loan amount, which is a function of your salary.
Why LTV is Important?
LTV is the second factor driving the size and price of the property you can buy. Lenders offer their mortgage products based on LTV. These range from 95% all the way to 50%. The deposit required to apply for a mortgage product is a function of LTV and is calculated easily using the following formula:
Deposit = (100% – LTV) x Property Value
This means that a product with an LTV of 90% will require a 10% deposit. You may be able to borrow hundreds of thousands of pounds but if you don’t meet the deposit requirement, you cannot apply.
Another reason why LTV is important is the interest rate. Products with higher LTV tend to have higher interest rates and vice versa.
Interest Rate
So different mortgage products have different LTVs with different interest rates. But what determines these interest rates? All lenders start with the central bank’s base rate. They then add your credit risk premium and their profit rates to work out the interest rate for each product. The higher the base rate, the higher the interest rates will be on mortgages.
Fixed Rate vs Variable/Floating/Adjustable Rate
There is yet another factor affecting the interest rate of your mortgage. We explain the differences below.
Fixed-rate: As the name implies, this rate is fixed for some time period. This period varies from 2 all the way to 10 or maybe 15 years with some lenders in the UK. In the US, some lenders fix the interest rate for the entire mortgage term!
- The interest rate increases as the fixed interest period increases.
- Offers certainty about the cost of your mortgage but with some restrictions.
- Such restrictions include a limit on overpayments and early settlement fees in case of selling.
Variable/Adjustable/Floating Rate: This rate usually kicks in when your fixed interest rate period ends. It is linked to the central bank’s base rate.
- Usually is more expensive than fixed rates.
- More flexible and allows you to switch lenders, sell and overpay with minimal restrictions.
- Be careful, floating rates can increase suddenly and increase your monthly payments with them.
Fixed-rate deals are more sought after; when mortgage hunting, your objective is to find the lowest fixed rate for the longest period of time.
Mortgage Term
The last input to the mortgage puzzle is the mortgage term. This can be anywhere between a couple of years to 35 years. Some lenders will only limit the age of the applicant at the end of the mortgage term to 65 or 75 years. The mortgage term affects the monthly payments and the total interest paid. Longer mortgage terms will lead to lower monthly payments but higher interest, and vice versa. Check out the mortgage calculator below and play with the inputs to see how different inputs affect your payments.
The Home Buying Process
The mortgage application process is long and tiresome. Plus, it would not be a complete mortgage guide without an overview of the application process, so here it goes:
- Check Your Finances: Before doing anything related to the mortgage application, you need to check your credit score and liquid savings. Make sure your credit score is good and do not make any credit application in the months leading up to your application.
- Shop around: Most first-time buyers make the mistake of going to their bank for a mortgage. You should shop around for the best rates and for a product that works for you.
- Pre-approval/Decision-in-principle: Get pre-approved with your lender of choice before you start shopping for a home, This will provide you with a budget and will indicate that you are well-positioned to move quickly with the purchase. In the UK, this is called a decision-in-principle.
- Gather documentation: You will need to provide a lot of documents to your lender. Payslips, bank statements, tax statements (P60 in the UK), proof of identity, and a bunch more. Start early to accelerate your mortgage application and get things moving quickly on your purchase.
- Find a home: Once you know how much you can borrow, which will be stated in your decision in principle document, you can start looking for a home that fits your budget.
- Make an offer: If you find a home that you want to buy, you will need to make an offer to the seller. Providing the decision-in-principle document to the agent will boost confidence in your offer. This means you will come across as a serious and ready buyer and give you some leverage to negotiate in a buyer’s market.
- Get a home buyer survey: This is an absolutely critical step. A home buyer survey will assess the state of the property and identify any problems that may need further investigations or intervention/repair. Some reports also include a valuation on the property, which is a good sanity check. You can and should update your offer if the survey identifies expensive repairs due to damp for example.
- Get a mortgage: You will need to apply for a mortgage when your offer is accepted. This will involve filling out an application and providing a bunch of documents to your lender. You do not need to wait for the home buyer survey report to get started on this. In fact, if you are set on the property regardless of what might come up on the survey, you can strategically wait till the conveyancing process to start re-negotiating the purchase price.
- Underwriting: Once your lender has received all of your documentation, they will begin the underwriting process. This is when they review your application and decide whether or not to approve your mortgage. Unless you have grossly misrepresented your finances during the pre-approval application, it is unlikely you will get rejected for the mortgage.
- Get a Conveyancer: When you get accepted, you will need a solicitor to take care of the contracts, searches, and settlement of funds. This part takes the longest so make sure you get a good solicitor and you stay in close touch with them.
- Closing/Completion: Congratulations, you now own a new home. Swing by the agents office to collect the keys.
In Conclusion
There you have it, all the mortgage fundamentals you need to go out there and get the best mortgage out there. We covered LTV, interest rates, rate types, and the application process in this mortgage guide. Next, we will cover the fundamentals of real estate investments, so sign up for our newsletter below to get notified of our articles.
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