Beginner's guide to mortgages

What is a mortgage?

A way of borrowing using your house or flat as security. It's less risky for the lender than a personal loan, because it can, if you default, sell your property to repay what you owe.

Do I need a deposit?

You generally need to have some money to put towards the cost of the house - this is a deposit. Most lenders want you to have a deposit of at least 5% of the value of the property, so £5,000 on a £100,000 flat. The bigger your deposit, the lower your monthly mortgage payments. Some lenders offer particularly good terms if you have a deposit of a quarter of the value of your property.

Many lenders levy a high lending charge (HLC) on loans of more than 75% of the property's value. But many lenders don't, and even those that do will normally have some mortgage products without HLCs.

If you can't afford a deposit, some lenders give 100% mortgages - an advance that covers the whole price of the house. But lenders may charge a higher interest rate for the privilege as well as an HLC.

How much can I borrow?

Traditionally, three times your annual gross salary, and two and a half times a couple's joint salaries. Now, however, many lenders will let you have up to five times your salary.

Don't necessarily borrow as much as a bank will lend, though. Work out how much you can comfortably afford to pay every month. If you're likely to have children, consider whether you'd still be able to meet the payments.

You can choose to pay your mortgage in two ways - repayment or interest-only.

Repayment mortgages

Each month you pay interest on the loan plus some of the money you borrowed (the capital). At the beginning of the term the monthly repayment is mostly interest, but a few years down the line, the interest portion is less and the capital more. The last payments are nearly all capital.

The advantages of a repayment mortgage:

• They are easy to understand.
• They are safer because there's no investment risk involved.
• You can shorten the mortgage term by making extra capital repayments.

Interest-only mortgages

You only pay interest on the loan, and your loan amount stays the same until the end of the term. An interest-only mortgage is meant to have some savings scheme running alongside it, which will have enough in it to repay the whole loan at the end. This could be:

• an endowment policy
• an ISA
• a personal pension plan - a quarter of the pension pot can be taken as a tax-free lump sum on retirement, and this can be ear-marked to pay off your mortgage.

The advantages of an interest-only mortgage:

• Your investment may end up yielding more than you need to pay off the loan.
• It can be cheaper to repay.

Fixed rates vs variable rates

Lenders charge interest on your loan, but you can choose whether you want them to use:

• a variable interest rate - where the rate will follow bank base rates, which depend where the Bank of England decides to set them;
• a discounted variable rate - as above, but with the lender knocking a couple of points off the rate for a limited period;
• a fixed rate - which doesn't change for an agreed period, so you'll know more where you stand but will on average end up paying more;
• a capped rate - where the rate follows base rates, but won't go above a certain level.

Special offers tie you in

Some mortgage deals are so cheap that they're only profitable if you're forced to stick with the same lender on a worse deal for a few years afterwards. If you move to another lender within a specified period, you may have to pay a penalty of £10,000 or more. This is a tie-in, and may be worth accepting if your finances need a breathing space for, say, the next two years. Just be aware of what you are committing yourself to. Your monthly payments could grow to three times the original level for five years - with nothing you can do about it.

Incentives

Weigh up all the incentives a lender offers with a particular mortgage:

• cashbacks or rebates - money paid back to you
• free mortgage valuation
• free legal fees
• free accident, sickness and unemployment insurance for a period - be sure to cancel this after the free period if you don't want it.

... and find out whether there is an arrangement fee, and how much it is - some are as much as £2,500, or more.

Flexible mortgages ...

... take many shapes and forms, but the principle is that you can pay more off your mortgage when you want, but still have access to that money again if you need it. You can usually take a break from payments for a few months too.

... and offset mortgages

... or current account mortgages, which are ultra-flexible home loans which take the form of an overdraft. You can pay more in, or draw money out, and the interest you pay depends on how much is outstanding each day.

Obviously, you need to be quite self-controlled for this to work. And the interest rate on offset mortgages is usually higher than on more conventional mortgages.

Mortgages for the self-employed

Lenders want proof of your income when they give you a mortgage. For self-employed people, they often want three years of audited accounts. If you're not able to produce that, you can opt for a self-certification mortgage, where they take your word for it. But these mortgages usually carry a considerably higher interest rate, and you can't borrow as high a percentage of the property's value.

Bad credit rating?

Even if you've been unable to pay bills in the past, or have had a county court judgement against you, there have been lenders who would still give you a mortgage. They are called "sub-prime lenders", and they usually charged a higher interest rate to compensate them for what they see as a higher risk. However, sub-prime loans have become virtually impossible to come by following the financial repercussions of 2007, when many lenders in the US lost money in this particular segment of the mortgage business.

Be prepared to switch

In today's competitive market, you may pay less interest over the life of your mortgage if you're willing to switch mortgage provider every few years. Most mortgage products are based on an offer - of discounted or fixed rates - which runs for a number of years. When that expires, your loan will normally revert to the lender's standard variable rate - almost always worse value than the offer you were on.

Two months before your offer expires, shop around for the best remortgage deal. See if your lender will match it, as this will save you the hassle and expense of actually switching.

But... arrangement fees on bargain mortgages can now be so high that it's only worth switching if you're on your lender's standard variable rate.

A mortgage is a big commitment - always make sure you understand everything before signing. You can ask a solicitor to read through the mortgage documents first.

See also our Guide to selecting a mortgage.

The content of this article is intended for general information and personal use only. Nothing in this article should be construed as advice under the Financial Services and Markets Act 2000.

©2008 Rachel's Guide to Money