Throughout the UK, the most common form of home loan by far is a residential mortgage. This is typically what people imagine when they think of a mortgage - it’s your basic bread-and-butter loan to cover the cost of buying your own home, and most homeowners in the UK have a residential mortgage of some sort. Understanding the basics of mortgages is vital before you begin shopping around for one, because they can sometimes work in surprising ways. Grasping the basics of how a mortgage works and how to get one is the first step towards purchasing your own home, and this guide will take you through the nuts and bolts of a UK residential mortgage. Bear in mind that you should always consult a qualified financial advisor before proceeding with a real estate purchase, to ensure that your mortgage product is well-suited to your needs.
What is a residential mortgage?
There are many different types of mortgage, all of which are regulated in different ways. For instance, a commercial mortgage for business premises won’t be subject to the same rules and regulations as a mortgage on your home, and neither will a mortgage for a buy-to-let property. Residential mortgages are regulated by the Financial Conduct Authority (FCA) which is responsible for ensuring that borrowers get fair service from their lenders.
A residential mortgage is required for any property in which you or a close family member will be living for more than 40% of the time. This covers your main address, but residential mortgages are also used for holiday properties and second homes; there are additional rules that cover these properties, namely a more expensive Stamp Duty fee, but for most purposes a residential mortgage is used for a property that you’re going to live in and not let out.
Residential mortgages are some of the most flexible and adaptable loans available in the marketplace, and while lenders themselves have strict criteria for their customers there are also many different options to choose from, which enables buyers to select a mortgage that works for them.
Basics of a residential mortgage
In order to understand how to choose the best mortgage for you, it’s first necessary to grasp the basics of how a mortgage works, and why certain mortgages are better for certain situations. Essentially, a mortgage is just a very large loan with a long repayment period, and the bank operates just like any other lender. The bank’s underwriters will take a variety of factors into account in order to determine how likely they are to get their money back, and will set a price that reflects how risky they believe the loan to be. The more certain they are that they’ll be repaid, the cheaper a mortgage will be, while if they think they’re taking a risk they’ll charge a lot of interest to offset their potential losses.
A mortgage is a “secured” form of lending, which means that the lender has a claim to repossess your property if you fail to repay them. The bank’s money is secured on the home you buy with it, so if you don’t keep up mortgage payments then they can choose to sell the house instead and make their money back that way. From their point of view, this isn’t particularly desirable; selling a house is a hassle, and they’d much rather you kept up payments instead. However, much of an underwriter’s job consists of determining how easy it will be for them to recoup the mortgage by selling off your home, as this is their safety net.
Interest and Repayments
In order to make a profit banks will charge interest on the loan they give you, which will be added to the repayments you make on the loan. These repayments will be used to repay both the interest on the loan and the loan itself (the “capital”), so that by the end of the mortgage term you’ll have paid off the whole loan as well as all the interest. This is known as a “repayment mortgage”, which almost all residential mortgages are. “Interest-only” mortgages have been phased out in recent years, but as the name implies these mortgages allowed borrowers to repay only the interest on their loan and not the loan itself.
The total cost of a mortgage is broken up into monthly payments. The longer you spread your repayments over, the smaller each individual payment will be; the payments on a 30-year mortgage will be cheaper than those on a 25-year mortgage. However you’ll still pay interest every year, and since you’ll be paying interest for an additional 5 years you’ll end up paying more overall for a longer mortgage, even though the month-to-month payments are lower.
Amortization
One concept that’s important to understand is an “amortization schedule”. In essence, this is a way of averaging out the costs of owning a home over the course of a mortgage. Imagine you took out a £100,000 cash loan at 2% per month; in the first month, let’s say you pay back £10,000 of the loan plus another £2,000 in interest for a total of £12,000. In the following month, you pay back another £10,000, but only pay interest on the £90,000 that’s still outstanding, reducing your monthly bill to £11,800 (£1,800 of which is interest). If mortgages worked like this, you’d pay a huge amount of interest when you first bought a home, and this would slowly decrease over the years.
This causes a problem for borrowers, because when you first buy a home you’re typically short on cash, and can’t afford to pay a big interest bill: instead, mortgage providers work out how much interest you’d pay over the course of the mortgage, then average this out over the years. This doesn’t reduce your overall interest bill, but it does mean you pay it in even instalments rather than front-loading it at the start of the mortgage.
Getting a cheaper mortgage
When you’re borrowing hundreds of thousands of pounds over several decades, any slight saving you can make is worthwhile. Even a tenth of a percent off your interest rate will make you significant savings in the long run, so it’s worth doing whatever you can to make your mortgage as cheap as possible.
The best way to make your mortgage cheaper is to increase your deposit. This is often easier said than done, but is the most surefire way to make a saving. From the bank’s point of view the more money you have tied up in the property, the easier they’ll find it to make their money back; if they’ve lent you only half of a property’s value as a mortgage, they won’t struggle to reclaim this money if they need to repossess the property. The less money you put in, though, the more they’ll have to sell the property for, which makes it more difficult for them to recoup their losses.
Many mortgage lenders allow buyers to take out a mortgage with as little as a 5% deposit. Because the lender is contributing 95% of the property’s purchase price, these are known as 95% Loan-to-Value (LTV) mortgages, and they are amongst the most expensive loans available. Buyers who can provide a 10% deposit will find mortgages appreciably cheaper, though this can represent quite a significant amount of money. Bear in mind that the cheaper the property, the further your money will go; £15,000 may only give you a 5% deposit on a £300,000 house, but will constitute a 10% deposit on a £150,000 property. It can be worthwhile to purchase a cheaper property with a cheaper mortgage initially, because this is much more affordable than taking out a high-LTV mortgage on an expensive property.
The second way to make your mortgage cheaper is to provide the bank with the best evidence possible that you’re a trustworthy borrower. Banks will look at your credit history and personal circumstances in order to determine whether you’re a potential risk or not, so it’s well worth taking the time to improve your credit history before taking out a mortgage. If you’re not sure how to do this, read through our guide to improving your credit history, which will walk you through the basic steps of creating a financial back story that supports your mortgage application.
Types of mortgage
There are many different ways in which residential mortgages can be structured, and different types will suit different borrowers. It’s important to find a mortgage plan that suits you, and these are a few of the most common different types of mortgage available to buyers in the UK.
Standard Variable Rate:
The standard variable rate (SVR) mortgage is the most common form of mortgage in the UK, and is the preferred mortgage of most lenders. The interest rate on an SVR mortgage is variable, hence the name; banks can charge a higher or lower interest rate whenever they choose, which allows them to respond quickly to a changing market. For instance, if the Bank of England makes it more expensive for banks to borrow money, they’ll want to increase the rates on their mortgages in response to avoid losing money. Of course if interest rates fall borrowers stand to save money, so the SVR can potentially be a bonus.
Most mortgages will default to a variable rate after an initial “honeymoon period”. Bear in mind that it’s usually possible to remortgage after a few years, so borrowers can switch providers in order to avoid this potentially expensive interest rate.
Tracker Mortgage:
A tracker mortgage operates in a similar way to an SVR, except that the bank has less control over how and when it changes the interest rate. Rather than banks being free to choose to set interest rates at will, a tracker mortgage’s interest rate directly follows the Bank of England base rate. This means that the interest rate will only change when the base rate changes, and won’t move any more or less than it does - because the base rate is generally perceived to be more stable than an SVR, a tracker mortgage provides more predictability.
Tracker mortgages are usually expressed as a certain percentage above the base rate - for instance, a mortgage that tracks at 2.5% above the base rate would be “BBR +2.5%”. In this case, if the base rate was 1.5% then the borrower would be charged interest at 4%, and if the base rate increased to 2.5% they’d be charged 5%. Borrowers can often choose between a low tracker rate and a long period of tracking; a potential option might be a 2-year tracker period at BBR +2% or a 5-year tracker at BBR +3.5%. This means that buyers have the option to keep the stability of a tracker for longer in exchange for a more expensive overall deal - whether this suits you or not depends on your personal situation.
Fixed Rate:
The third common form of mortgage is a fixed rate, which as the name implies has an unchanging interest rate. By freezing the cost of their mortgage borrowers can budget more easily, without having to worry about whether interest rates go up or down. This can be extremely useful for new buyers who’ve put every penny into a deposit, and can’t afford to pay a higher interest rate. Bear in mind that while a fixed rate mortgage protects borrowers from increasing interest rates, they also prevent them from benefiting if rates decrease. Therefore fixed-rate mortgages are most appealing when interest rates are low, and less appealing when they’re high.
As with a tracker mortgage, fixed rate mortgages typically only last for a few years before defaulting to an SVR. Big deposits pay off here, as borrowers who can put up a decent chunk of their property’s purchase price get access to the best deals - longer fix periods and cheaper interest rates, which can pay big dividends.
Bear in mind that banks stand to lose money if they fix rates at a low level and the price of borrowing then increases. Because of this, banks will often hedge their bets by offering a fixed-rate mortgage at a relatively high rate, rather than at an immediately competitive rate. However, fixed-rate options are often comparable in price to the SVR mortgages on offer from many lenders.
Offset Mortgages
Offset mortgages are a fairly niche form of mortgage which allows borrowers to offset their savings against the total amount of their loan they pay interest on. With a standard repayment mortgage, the borrower will slowly build up equity in their property as they make repayments; the money they use to pay back the loan increases their ownership of the property. Money invested in real estate is generally pretty safe, but it isn’t flexible; if you want to use the money tied up in your home for anything, you’ll need to remortgage the property.
Instead, an offset mortgage allows borrowers to reduce the amount of mortgage they’re paying interest on whilst still holding cash savings. A typical example could be a family with a £250,000 mortgage on which they’re paying 4% per year (which comes to £10,000 in interest alone). Rather than ploughing all their money into repayments, they can invest £20,000 of their savings in their offset mortgage, which reduces the amount they’re paying interest on from £250,000 to £230,000. They’ll still pay 4% interest on this, but they’ll only have to pay £9,200 per year - an £800 saving.
The downside is that most banks don’t pay interest on savings held in an offset mortgage, so your money won’t be growing whilst it’s invested here. As the saying goes, though, “a penny saved is a penny earned”, so money which is saving you from paying 4% interest might as well be earning you 4% interest instead - whether this is the best way to save or not is up to you, and varies from one individual to the next.
Applying for a mortgage
So, how do you go about actually getting a mortgage? The first step is to find the right lender for you. There are plenty of price comparison websites that will help you find the best deals, though be aware that not every site will list every lender on the market - you should shop around to find the best deal. Many lenders will also have a residential mortgage affordability calculator on their website, which will help you to understand what sort of deal you can expect to receive from them.
Once you’ve found a good deal, it’s time to submit an application. The preliminary application process is fairly straightforward, and you won’t need to provide a lot of supporting documentation before going ahead with it. Most preliminary applications only take 15-20 minutes to complete, after which the lender will decide whether you qualify for a mortgage. If you do, you will be “pre-qualified”, which is to say the lender thinks you may be eligible to take out a mortgage with them. This is emphatically not an agreement to give you a mortgage; you must now complete a formal application.
The full mortgage application process in far more in-depth than your initial application, and you’ll need to spend more time providing personal details such as your employment history and personal situation; the bank will also check your credit history as well. If you’re successful, the bank will approve your application for a loan, and you’ll be given a “decision in principle” for a mortgage. This will state the amount the bank has agreed to lend you and the rates it will charge you. Estate agents will need to see evidence of a decision in principle before accepting a bid from you; otherwise, there’s no reason to believe you’ll be able to complete the purchase.
Bear in mind that a decision in principle is not legally binding; the bank can change its mind at any time and for any reason. If market conditions change, for instance, they may decide that you need a bigger deposit, or that you simply don’t meet their criteria. A decision in principle should not be treated as a cast-iron guarantee, and it can be worthwhile to secure more than one just in case a lender pulls out.
Remortgaging
While a mortgage term might be for 25, 30 or even 40 years you aren’t committed to staying with a single lender for the entire duration of this term. Borrowers are free to leave at any point during a mortgage in search of a better deal, and it’s become much more straightforward to do so in recent years. While it’s still not as easy as switching energy supplier or a current account, mortgage switches have been streamlined to just a few weeks in the past few years, making it easier for homeowners to search out the best deals on the market.
Before agreeing to a mortgage deal, you should check to see what their early repayment terms are; many mortgages charge a hefty fee for leaving early, and most borrowers won’t want to incur these charges by switching while these charges are in effect. Often the early repayment period coincides with the “honeymoon” period, when the mortgage is on either a fixed or tracker rate - once this expires, the mortgage holder is free to switch to a new lender.
Remortgaging can be a great way to acquire a cheaper mortgage, because after several years a borrower will have built up a little more equity in their property. When switching to another mortgage provider this equity will count as a larger deposit, allowing the homeowner access to better interest rates and better deals. Bear in mind that the majority of the repayments you make in the early years of a mortgage will go towards paying off the interest on the mortgage and not towards building up equity, so it’ll take a while to build up a sizeable chunk of equity in your home.
UK Residential Mortgages and home ownership
While acquiring a mortgage can sometimes be a long, arduous task, the range of options on offer to UK buyers provides a wide variety of solutions for different borrowers. By selecting the type of mortgage that best suits their needs, buyers of UK real estate can minimise the costs of owning a home and maximise the return on investment from their property.
