Mortgages explained

House - mortgagesThere are different types of mortgages, which depend on how you pay back the loan itself, the interest and how quickly you pay them back. The money you borrow is called capital, but the total you pay back includes the capital and interest.

Paying back the capital

You can take out a mortgage where you pay off the capital a little at a time, with interest, or you can pay just the interest and save to pay off the capital at a later date. Some banks allow you to pay off capital in lump sums every so often, which is worth doing because it reduces the amount of total interest you pay.

Repayment mortgages: You may, for example, take out a loan for a 25 year period. The lender works out what the interest is over that 25 years and calculates the total cost of the loan, which then tells you how much you must pay each month for 25 years (assuming the interest rate doesn’t change). For the first few years, you are paying mostly interest and the capital doesn’t reduce much, but as you get towards the end of the 25 year period, a higher percentage of your payment is paying off capital.

Endowment Mortgages: An endowment is like a life insurance policy with a savings scheme, where you pay for insurance and put money into a fund that hopefully accumulates enough interest to pay off the loan at the end of the term. Endowments have been seen as a bad idea in recent years because many people have found that, because of the bad financial markets, their endowments have not covered the cost of their loans, and they are left owing more money at the end. They are cheaper than repayment mortgages though, so it would be a good idea, if you have an endowment, to pay separately into an ISA or other savings account. Then, if your endowment is too small when it matures, you can use money from your other savings account to pay off the debt. If your endowment covers your loan, then you have a nice big savings account full of money.

Individual Savings Account (Isa) mortgages: These are similar to endowment mortgages.

Pension mortgages: Are similar to both ISA and endowment mortgages, but work on the basis that pensions (both private and company) provide tax-free cash on retirement. At the end of the mortgage term the loan is paid out of your tax-free lump sum.

Paying the interest

The interest is the part of the mortgage that often affects who you borrow from. Different lenders offer different rates and different incentives to get you to borrow from them.

Variable rates: Quite simply, this means the rate of interest you pay varies according to the market rate. If your lender offers 4% at the time you borrow your money, and six months later they increase their rate to 4.25% then your interest due (and monthly payments) increases incrementally.

Fixed rates: You’d be hard pressed to find a mortgage at a fixed rate for the life of the mortgage but commonly you can find a time limited fixed rate. If, for eaxmple, your rate is fixed for two years at 4%, then you will not pay any more even if the bank rate goes above 4%. This does also mean, though, that you will also not save if the rate falls.

Capped rates: These are fixed, but if rates fall you pay the lower rate. This is a popular method of repayment for first time buyers.

Cash back deals: This is when lenders offer money back if you take out a particular product. Be wary though about the overall cost. If a bank promises, say, £5,000 cash back when the mortgages is given to you, this may well be written back into the life of the mortgage somewhere, so you do end up paying it back. Compare the overall cost of this mortgage with one that doesn’t have cashback to ensure you don’t end up paying more. It is a good way of reducing the up-front cost of a move.

Discounted rates: Your mortgage may run at a discounted rate for, say, two years, meaning you still have a variable interest rate, but during the discounted term, you pay a percentage point or two below the market rate.

Questions to ask your lender

  • If you are talking to a broker, ask them what commission they are being paid by the lender.
  • Can I make lump sum payments to reduce the size of the loan?
  • Are there any penalties if I pay off the loan early?
  • Does this mortgage come with compulsory insurance?
  • What other charges will I have to pay?
  • What happens if I can’t pay?

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