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What Are Mortgages And How Do They Work?

Posted 19 February 2018 by Nick Parkhouse

Want the mortgage basics? Here’s your complete guide to mortgages – what they are and how they work...

If you want to buy a house, the chances are that you will need the help of a mortgage. Unless you have the entire cost of the property in the bank you will need to borrow some money to meet the asking price.

But what is a mortgage? How do they work? And what different types of mortgage are available? Keep reading for answers to all these questions and more.

What is a mortgage?

A mortgage is a special type of loan that you take out when you want to buy a house.

As the average cost of a home in the UK is more than £225,000, most people don’t have the cash available to buy a property outright. A mortgage lets you borrow against the value of the property and pay it back, with interest, over a fixed number of years.

A mortgage is a ‘secured’ loan. This is because the borrowing is secured on the property.

What this means is that if you fail to keep up the repayments, the lender can use the courts to take possession of the asset (the property) in order that they can recoup their money.

How do mortgages work?

When you take out a mortgage a lender lends you a percentage of the value of the property. Generally, you can borrow up to 95% of the value of the property. You provide the remainder as a cash deposit from your own savings.

The lender secures the loan on the property and you agree to pay back the amount you borrow, plus interest, over a set period of time. This is typically around 25 to 30 years.

Once you have repaid the loan your mortgage ends and you own the property outright.

Mortgages can normally be taken out in a single name, or in joint names. Joint applicants can be partners, siblings or friends.

Interest only vs repayment mortgages

When you take out a mortgage there are two main ways that you can structure the loan.

Repayment (‘capital and interest’) mortgage

Under a repayment mortgage, your monthly payment consists of:

  • Some of the actual mortgage loan (the ‘capital’) that you borrowed
  • Some of the interest the lender has charged.

As time goes by and your overall debt gets smaller, the amount you owe in interest reduces. This means that more of your monthly payment goes towards paying off the money you borrowed. If you make all your repayments on time, at the end of the mortgage term you will have repaid everything that you owe.

If you move within the mortgage term you may be able to take the mortgage with you. This is called ‘porting’ your mortgage and you can read our guide to this here.

Interest only mortgage

Under an interest only mortgage, your monthly payment consists of:

  • Interest on the amount you have borrowed.

As you don’t pay any of the capital that you have borrowed as part of your monthly repayment, the total amount that you owe does not reduce.

At the end of the loan term you will have to find enough money to repay the whole debt. This may be through savings that you have contributed to over many years, from an inheritance, or from another source.

Interest only mortgages have lower monthly repayments, but they are riskier as you need to make sure you have enough cash to pay off the loan at the end of the term.

Different types of mortgage explained

Once you have decided whether you want an interest only or repayment mortgage you then have to decide what type of mortgage deal you want.

Your main choices are:

  • A fixed rate – this guarantees your repayments at a fixed amount for a specified period. It gives you certainty that you know what you’re going to pay, but also means you are committed to that deal for the fixed period.
  • A tracker rate – your repayments will follow the Bank of England base rate. If the rate falls, your payments will reduce. If the base rate rises, your interest rate and repayments will also rise.
  • A discounted variable rate – your repayments are linked to your lender’s Standard Variable Rate (SVR). When your lender changes their SVR your repayments will rise and fall accordingly.
  • An offset mortgage – you link your savings to your mortgage. The amount of savings you have effectively reduce your mortgage balance, helping you to pay less interest and repay your mortgage faster.

Find out more about the different types of mortgage that are available, and the pros and cons, in our guide.

What does a mortgage cost?

The monthly cost of your mortgage depends on:

  • The amount that you borrow
  • The interest rate that your lender charges
  • The mortgage term (how many years you take the mortgage over)
  • Whether you choose a repayment or an interest only mortgage.

When you take out a mortgage you may also pay some associated costs and fees. These can include:

  • A valuation fee
  • A product or arrangement fee to secure a particular interest rate
  • An advice fee.

Find out more about the different type of mortgage fees and costs in our comprehensive guide.

Where to get a mortgage

With thousands of mortgage products available, finding the right one can be tricky.

There are dozens of lenders in the UK, from High Street banks to your local supermarket. You can apply for a mortgage direct from a lender and if you do this you will get a choice of deals from their product range.

You can also speak to an independent mortgage adviser or mortgage broker. Mortgage brokers can compare different mortgages on the market from different lenders. Some brokers compare the ‘whole market’ while others look at deals from a panel of lenders.

If you’re taking a mortgage out for the first time it can pay to get some professional advice.

 

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