Mortgages explained for first-time buyers
Over the past few years the perils of the mortgage market have been graphically illustrated, with the prospects of obtaining a home loan changing dramatically from the sublime to the ridiculous.
Now the state-backed Funding for Lending scheme, operated by the Bank of England, has started to breathe some life back into the market.
The mortgage rates now available have plunged and lenders are beginning to compete again.
What is more, there are signs that this competitiveness is not just in the areas where a large deposit is needed.
Products that only require a deposit of 15%, 10% and even 5% of a property's value are starting to appear once more at affordable rates.
All this means that first-time buyers are beginning to cast their eye on the market once more, especially as rents are getting more expensive.
So, the question is, how do you safely navigate through the mortgage maze, finding out what types of mortgage are out there and what is best for you?
Although competition among lenders is increasing, most are still choosy about to whom they lend. Preparing for a mortgage starts early, so make sure your documentation is in order.
Make sure you are on the electoral roll at your current residence. If you have never had any credit in the past it can be worth taking out a credit card and using it sparingly, making sure it is paid off in full at the end of each month. This helps to build your credit score.
Lenders like to see your address history for the past three years - with no gaps, payslips from the past three months, and your last P60 or three years of accounts, your last three months of bank statements, and full details of any loans or credit cards you may have.
Providing this information on day one can speed up the process no end.
Agreement in principle
To make sure you have the best chance of securing the home that you make an offer on, you should secure a mortgage "agreement in principle" (AIP).
This will involve a full credit check by the lender and confirm in writing how much they are prepared to lend to you, subject to them checking the information you have given to them. This AIP can then be used to confirm your credit worthiness and seriousness as a bidder to the seller of the property.
The basis of any mortgage, whether you opt for a fixed, variable or tracker rate, is how you intend to repay the loan. In essence there are two repayment options:
- Capital and interest, or repayment, mortgages work as standard loans do. The monthly payments include not only the interest due on the loan, but also little bits of the capital balance. As the loan begins to reduce, slowly at first, so the interest element becomes smaller while the capital repayments become a larger part. Therefore at the end of the term, providing the repayments have been made every month, you know the loan will be paid off without risk.
- Interest-only. This loan does not include any capital repayment at all, so the capital does not reduce unless you overpay each month, or you set up some other savings, such as an individual savings account (Isa), to grow over the years to repay the loan. There is a risk involved in this method as if you do not have sufficient funds available to repay the loan at the end of the term, you may have to sell your property.
In recent years, many borrowers took out interest-only mortgages without setting up savings accounts to work alongside their loans.
Instead, they relied on the growth in value of their properties. As property prices stagnated, or even fell, this created numerous issues, so lenders have recently moved away from interest-only mortgages.
Lenders have now changed their criteria for interest-only mortgages. Many only permit interest-only for those with 50% equity, for loans above £300,000, or those with a proven existing repayment plan.
For most borrowers now, budgeting on a repayment mortgage basis is essential.
Fixed, tracker or variable?
Once the repayment method is decided, there are lots of individual rate choices.
It is important to work out which product would be best for your circumstances and often the cheapest looking products may have the highest fees or not have the flexibility required. All this could cost money in the longer term.
- Fixed rates are as simple as they sound. This is where you agree to fix at the same rate for a set period of time, normally two, three or five years. This can give some much needed peace of mind as there will be no changes to your mortgage payments, allowing you to budget accordingly.
There are normally tie-in penalties, or redemption penalties, within the fixed-rate period that mean you are unable to repay the whole loan without a cost penalty being imposed. For example, with a five-year fixed rate repaying the loan early could involve a fee of 5% of the loan amount being charged on top of the amount you owe.
For many people, this is not an issue as the security of the fixed rate saves on sleepless nights worrying about interest rate increases.
- Tracker and variable means the rate can change at any time owing to decisions by the Bank of England or by your lender.
The most popular type of variable rate is the tracker mortgage. These track the Bank of England base rate over a certain period of time, from two years to the whole length of the mortgage. For example, if the product is set at 2% above the Bank rate, which is at 0.5% now, the initial rate would be 2.5%.
However, if the Bank rate increased to 1.5%, payments would then be based on 1.5% plus 2% which equals 3.5%, hence the greater risk element. Of course this can also move downwards, reducing your current rate.
Some trackers do have more flexible options than fixed rates, such as the ability to cap the amount that rates can rise, or to offset your mortgage with any savings you may have, or to simply repay larger amounts without penalty.
These were usually seen as being cheaper than the insurance of the fixed rate. However, now that interest rates have hit a historical low, with not much expectation of further movements in the short-term, lenders have moved their attention onto fixed-rate products.
Buoyed by the Funding for Lending scheme, there is now a highly unusual situation where some of the cheapest products are fixed-rate deals rather than tracker products.
In the past many borrowers who should have taken the security of a fixed rate were tempted by lower tracker rates, but the tables have now turned.
The next few months could be the best time to take a fixed rate for a generation.
For most people a mortgage is the biggest loan that they are ever going to take out, lasting between five and 35 years, so it is important to make sure that the product chosen suits you. What is right for your friend or colleague may not necessarily be the right one for you.
I would argue that taking independent advice from someone who knows every single product on the market is essential to avoid being caught out by small print or inflexible contracts that effect later life choices.
Being stuck in the middle of the mortgage maze is not much fun, especially when your home is at risk, but it can be easily negotiated with the help of a suitably qualified professional.
The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Links to external sites are for information only and do not constitute endorsement. Always obtain independent professional advice for your own particular situation.