What Are Mortgages And How Do They Work?

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Key Takeaways

Mortgages are loans used to purchase real estate.
First-time buyers are advised to use mortgage brokers or advisors when applying for a new mortgage.
A mortgage payment is a monthly payment, for a set period, debited from the borrower’s bank account.
The property is used as collateral (i.e. security) against the borrower and can be repossessed (by the lender) if mortgage payments are not adhered to.
Mortgage interest rates vary, depending on factors like an individual’s credit score.
There are many mortgage types, ranging from fixed-rate to variable-rate mortgages.

What Is A Mortgage?

A mortgage is a type of loan (i.e. money borrowed) specifically designed for purchasing real estate over a set period (e.g. 20 years). It allows borrowers (i.e. you) to access money from lenders (i.e. bank or building society) when they do not have enough money (i.e. lump sum) on hand in the home buying process.

This loan amount ‘bridges the gap’ between what you have in savings and the property’s purchase price; essentially giving you the lump sum to buy the property. However, borrowing money comes at a price and you will need to make monthly repayments to pay the money back.

Upon review of your current financial position, a mortgage contract is drawn up outlining the loan term, monthly repayments, interest rates and property taxes. This ensures you can afford the monthly repayments over a set period from your chosen mortgage lender.

Simply put: mortgage lenders purchase the property on your behalf and hold the real estate as security. This means if your mortgage payments are not adhered to, they have the right to take possession of or sell the property – a process known as foreclosure.

Mortgages are tailored to accommodate different financial positions and preferences. They range from fixed-rate loans, where the monthly payment remains constant, to variable-rate mortgages which fluctuate based on the UK property market’s interest rate.

Mortgage advisors or brokers are beneficial to use when navigating the complexities of mortgage loans, especially if you are a first-time buyer!

What are mortgage brokers and advisors?

You can get a mortgage loan from mortgage lenders with the help of a broker or advisor. They assist you with the mortgage process and mortgage application and will explain the relevant details about each mortgage deal. Essentially, they do the same thing but differ in functionality.

In a nutshell, the difference between a mortgage broker and a mortgage advisor is:

A mortgage broker acts as the middleman, between a borrower and many different lenders in the UK property market. They can provide a borrower with numerous mortgage deals that are best suited to your budget and needs.
On the other hand, a mortgage advisor is tied down to one loan company (Barclays Bank, for example). They only provide expert knowledge about various mortgage deals from their affiliated company and won’t mention mortgage loans that are cheaper elsewhere.

Is a mortgage and a loan the same thing?

A mortgage is a type of loan, but a loan is not a type of mortgage.

Essentially, both are forms of borrowing money over a set time period. Mortgages are specifically designed for purchasing real estate (i.e. properties or land), whereas loans can be used for various purchases (i.e. furniture, vehicles, etc).

How Do Mortgages Work?

When acquiring real estate, understanding the mortgage process and your mortgage term is crucial. As mentioned, a mortgage loan enables individuals (and businesses) to purchase properties without needing to pay the entire purchase price upfront. However, borrowers need to have a down payment (i.e. deposit) to secure the mortgage deal.

A down payment is a percentage of the property’s value. For example, if a house is valued at £400,000, a 10% deposit would equate to a £40,000 down payment. The mortgage provider will provide the remaining 90% of the money needed, which is known as the Loan-To-Value (LTV) rate.

The LTV rate measures the remaining property percentage rate that will be covered by the lender. For the above example, the mortgage contract would state that a 90% LTV rate of £360,000 is the borrowed loan amount.

Mortgage lenders consider various factors when drafting the mortgage contract, such as the borrowers’ financial position and credit scores.

These are used to calculate the monthly payments over a set period of time. A Debt-To-Income Ratio evaluates the borrower’s ability to manage each monthly payment, along with their existing debts. Mortgage payments are typically a direct debit from the borrower’s bank account

The borrower is liable to pay interest rates and property taxes, based on the type of mortgage application or mortgage rate set out in the loan term/s.

How Do I Get A Mortgage In The UK?

When applying for a mortgage, you must check your credit score beforehand. Your mortgage provider will use it to determine your mortgage rates and your particular interest rate. The rule of thumb is that the higher your credit score, the lower your interest rate will be.

Once you are satisfied with your credit rating report, you need to determine which type of mortgage deal you are looking for. Conventional mortgages are the most common as they usually only require as little as a 5% down payment.

However, these types of mortgages may not be suitable for all borrowers.

Before you get a UK mortgage, you will need to:

Find a UK property you wish to buy
Use a mortgage calculator to determine how much you can borrow
Save for the down payment (a type of deposit that is equal to a percentage of the entire property value). Various mortgage lenders have different down payment requirements.
Find a mortgage that is best suited to you (mortgage brokers can be helpful here)
Ensure you can afford the mortgage monthly payments
Get a Mortgage Agreement In Principle
Put in an offer to purchase with the seller
If your offer is accepted, apply for a mortgage

Note: Most lenders will require you to provide bank account statements, tax returns, credit scores, and employment status documents. It’s advised to have up-to-date copies of these on hand that are not older than 3 months.

What is the buying process?

Once you have your Mortgage Agreement In Principle and are ready to get a mortgage, you will then need to:

Prepare your documents: Ensure you have all the relevant paperwork on hand, including proof of identification (such as a passport), proof of address (e.g. latest utility bill), proof of income (e.g. 3-month payslips and P60), and proof of the down payment deposit.
Submit mortgage application: Complete and submit your mortgage application. Give your mortgage provider details of the UK property you wish to buy and the price you’ve agreed to pay.
Appoint a solicitor: Hire a solicitor to draw up contracts and manage the transaction.
Conduct a home survey: Arrange to view the property. Decide between a basic condition report, a more thorough homebuyer’s report, or a full structural survey for detailed insights into the condition of the property.
Exchange contracts: Once your mortgage has been approved, your solicitor will exchange contracts with the seller’s solicitor.
Completion: The final step involves the agreed-upon funds being released from the lender. This process is referred to as ‘drawdown’. At this point, you legally become the owner of your new home.

Types Of Mortgages

Fixed-rate mortgages

Fixed-rate mortgage payments are when the mortgage interest rate remains constant for the entire duration of the loan term. It is the most stable kind of repayment, meaning that the borrower pays the same amount every month. The interest rate is calculated at the outset of the loan term, safeguarding borrowers from possible interest rate hikes.

The mortgage term for these types of repayments can vary. Common terms include 2, 3, 5 or 10 years.

Adjustable-rate mortgages

Adjustable-rate mortgages (ARM), also known as variable-rate mortgages, have changing interest rates. This is based on the fluctuations of the UK property market. With this in mind, a borrower’s mortgage payment may increase or decrease each month.

ARMs often start with lower interest rates and monthly payments when compared to fixed-rate options, making them more appealing to borrowers. These rates are adjusted periodically, either monthly, bi-annually or yearly, depending on the loan contract.

Interest-only loans

Interest-only mortgage loans are types of loans in which the borrower is only required to pay the interest that accrues on the principal amount (the initial loan amount) each month. The principal amount remains unchanged during the interest-only payment period.

After this period ends – which can range from 5 to 10 years – the loan is amortised for the remaining mortgage term and the borrower begins to pay monthly payments. These payments cover both the principal and interest amounts.

Amortised refers to the process of gradually reducing debt over a specified period through regular, predetermined payments.

Reverse or Equity Release mortgages

Also known as Lifetime Mortgages, these are particular types of mortgages that allow homeowners, typically seniors over the age of 62, to convert a portion of their home equity (i.e. worth) into cash. This can be received as a lump sum, line of credit, or in monthly payments.

Unlike traditional mortgages, a reverse or Equity Release mortgage does not require the homeowner to pay monthly payments to a lender. Instead, the loan is repaid when the borrower sells the house, moves out for 12 consecutive months, or passes away.

Shared ownership mortgages

Shared ownership mortgages work slightly differently from other mortgages on our list. These UK government-backed schemes, designed to help individuals climb the property ladder, are usually aimed at new builds.

Borrowers take out a mortgage on the property – between 10% and 75% of the value – and the developer (or landlord) owns the rest of the property. Borrowers will pay monthly instalments on their portion of ‘owned’ property plus a monthly rental for the portion they do not own.

Comparing Mortgages

Fixed-rate mortgage vs. variable-rate mortgage

Fixed-rate mortgage

Fixed-rate mortgages have “fixed” (constant) interest rates throughout the entire mortgage term. These monthly repayments are stable and predictable, allowing the borrower to budget better. The interest rate is unaffected by the volatility of the UK property market, ensuring a constant monthly amount.

Typically, the mortgage rate is higher when compared to variable-rate mortgages. They offer limited flexibility, with penalties often incurred when wanting to pay off the loan in a quicker time frame.

Variable-rate mortgage

Variable-rate or adjustable-rate mortgage rates can change based on the UK market conditions. This means that monthly instalments can increase or decrease, depending on the market’s interest rates. This can pose as an advantage, especially when monthly instalments are decreased.

However, they can cause concerns or have risks involved should the interest rate spike, leaving borrowers with higher-than-intended rates to pay. In saying this, these types of mortgages offer greater flexibility and allow for additional payments to be made without incurring any penalties.

Interest-only mortgages vs. repayment mortgages

Interest-only mortgage

Borrowers only pay the interest charged on the mortgage term each month and not on the principal amount (i.e. the amount borrowed).

The original loan amount remains the same throughout the mortgage term but must be repaid in full at the end of the mortgage agreement.

Borrowers often use investment strategies to accumulate the funds to repay the principal amount at the end of the term. However, there is a higher risk with these kinds of mortgages. Not having enough funds at the end of the term, especially if investments have underperformed, can be risky.

Repayment mortgage

Borrowers pay a combined fee, including both the principal and the interest rate, in a monthly payment. The outstanding mortgage balance gradually decreases over the mortgage term. At the end of the mortgage term, the borrower fully owns the property as they have paid back both the principal and interest rate amounts. This is often considered a more reliable mortgage option.

How Much Do UK Mortgages Cost?

There is no “one price fits all” mortgage rate. A mortgage depends on several factors that are unique to each borrower. These are the typical factors that constitute mortgage rates:

Principal: This is the amount of money that is borrowed to purchase the property.
Interest: This is the cost of borrowing the money, shown as a percentage rate of the loan amount.
Interest rate: This is based on the type of interest rate you opt for, such as a fixed or variable rate, etc.
Loan term: This refers to the length of the mortgage (e.g. 15, 20, or 30 years) and affects the total cost of the monthly instalments. Generally, the longer the term, the more interest is paid.
Down payment: This refers to the initial deposit amount you can put down on the property. A larger deposit typically results in lower monthly payments.

Closing costs

Loan origination fee – charged by the lender to process the loan.
Appraisal fee – for determining the market value of the property.
Legal fees – solicitors fees for handling documentation and legal procedures.

Additional costs

Property taxes: These are local government taxes based on the property’s value.
Homeowners insurance: Also known as Title Insurance, this insurance covers homeowners against damages or potential ownership disputes, hence the name.
Private Mortgage Insurance (PMI): This may be required if down payments are less than 20% of the property’s value.
Homeowners Association Fees (HAF): These fees may be incurred if the property is part of a community, apartment complex, or gated estate.
Stamp Duty: These are types of property taxes that are levied when purchasing a property (or land) within the UK. In Scotland and Wales, it is known as the ‘Land and Buildings Transaction Tax’ and ‘Land Transaction Tax’ respectively.

Potential costs

Maintenance and repair: Ongoing costs to maintain and upkeep the property.
Utilities: Such as water, electricity and gas consumption fees.

FAQs

What happens once you have repaid your entire mortgage loan?

If you opt for a repayment mortgage, once your mortgage terms have come to an end, the borrower takes full ownership of the property.

If you opt for an interest-only loan, once your mortgage term has come to an end, the borrower first has to pay back the principal amount in full, before taking ownership of the property.

Why do people need mortgages?

The purchase price of most properties usually far exceeds what a typical household can save. This is where mortgages come in. They allow individuals, families, and businesses – who have the qualifying criteria – to purchase properties with manageable monthly instalments, over a period of time.

What does remortgage mean in the UK?

In essence, switching a mortgage to a new deal with a different lender is known as remortgaging. This can happen for various reasons, such as the desire to save money or the need to borrow more funds against your property’s value.

Most mortgages often make up the largest part of monthly household expenses. Therefore, choosing a deal that best suits your current financial situation is crucial.

How do I know if a mortgage broker or advisor is legitimate and regulated?

You can verify their registration and certifications with the Financial Conduct Authority (FCA). Look at past client testimonials and reviews to gain insights into their credibility and services.

Which UK banks offer mortgages?

Many UK banks, such as HSBC, Barclays Bank, Lloyds Bank, and NatWest Bank, offer mortgage deals. They usually have an independent mortgage advisor who can assist with individual circumstances, from first-time buyers to remortgaging and more.

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