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A Guide To Mortgages
A mortgage is a sum of money borrowed from a bank or building society in order
to purchase a property. The money is then paid back to the Lender over a fixed
period of time together with accrued interest. There are many different types of
mortgages and there will be one out there that best suits you.
Types Of Mortgage
There are essentially two different types of mortgage:
Repayment only, (capital and interest mortgage)
Interest only, (ISA, pension or endowment mortgage)
Your monthly repayments consist of repaying the capital amount borrowed together
with accrued interest. On your mortgage statement, normally received annually,
you will see that the amount borrowed decreases throughout the term.
At the end of the term, you are safe in the knowledge that the total amount of
the debt has been repaid.
Overpayments and lump sum payments into your mortgage account can be made
reducing both the interest and capital amounts repayable.
Life assurance cover is not always necessary in taking out this type of
There may be financial penalties for making lump sum/overpayments into your
In the early years of a repayment mortgage the majority of the monthly repayment
is interest rather than capital. For borrowers moving house regularly, this can
result in little of the capital being paid off.
If you have no life assurance cover in place and die before the loan is repaid,
the mortgage will still need to be repaid. This may result in the property
having to be sold to repay the debt owed.
With this type of mortgage, only the interest is paid off with each mortgage
payment. The borrower also takes out at the same time, an alternative ‘repayment
vehicle’ (method of paying off the mortgage) such as an ISA, pension plan or
endowment policy. More information about endowments (which in the 1980’s and
1990’s were extremely popular), ISAs and Pension plans are below. The most
important fact about an interest only mortgage is that the monthly repayments do
not repay any of the outstanding capital balance. As a consequence it is
important that the payments are maintained into the repayment vehicle otherwise
it will not be possible to pay off the mortgage at the end of the term.
· ISA Plan
The most common type of interest only mortgage which also provides life
assurance cover and a fixed payment for investment. The fixed payments are based
on the amount of the loan together with the mortgage term and are designed so
that, at maturity, the amount invested and earnings are sufficient to pay off
the mortgage. Much maligned in the press because of the poorer investment growth
rates achieved in a low inflationary environment this form of investment is less
popular these days. Note there is no guarantee that, when the endowment matures
and ‘pays out’, the balance will be sufficient to repay the mortgage.
Nonetheless millions of borrowers have one or more endowment policy and as a
rule of thumb these should not be cashed-in early and certainly not before
seeking advice from a suitably qualified financial adviser. Customers cashing-in
an endowment policy in the first few years after inception can receive less than
the amount invested. Existing endowments can be used to support a new mortgage
with any ‘additional lending’ over the value of the projected maturity balance
being covered on a repayment basis or with an alternative repayment vehicle e.g.
an ISA. It is also worth pointing out that historically the returns on endowment
policies have been pretty good (provided they go full term).
Endowments provide life assurance so that in the event of death the mortgage is
The Individual Savings Account (ISA) is a tax free method of saving. Using an
ISA as a repayment vehicle is growing in popularity but due to the ISAs
complexity it is only for the financially sophisticated or borrowers taking
advice from a suitably qualified financial adviser.
Life assurance cover is provided and monthly payments are made into a pension
fund. When the benefits are eventually taken, the mortgage is repaid using
tax-free cash from the remainder of the fund. The plan holder can then draw a
pension from the balance of the fund. This product, which tends to be used by
the self employed, is only for those taking advice from a suitably qualified
· If the proceeds of the plans exceed the amount required to repay the mortgage,
then this is received as a cash lump sum by the borrower.
· Some plans are tax-efficient.
· If the proceeds of the repayment vehicle do not achieve the amount expected,
then there will be a shortfall. The borrower remains liable for any shortfall on
the mortgage hence the outstanding balance will need to be paid off from other
resources. Regular checking of the policy fund itself by the borrower and the
lender should minimise any risk. If the plan is not reaching its expected
target, the borrower can increase payments into the policy or invest in another
product to cover any anticipated shortfall.
· Cashing in the plans early may result in financial penalties. These will be
provided for in the initial agreement. In addition the lender has no way of
tracking some of the more modern repayment vehicles, such as an ISA, which will
result in some instances where a borrower lets an investment lapse forgetting or
not realizing it is to be used to pay off the mortgage. This will result in
situations where there is no method of paying off the mortgage and the lender
will only become aware at the end of the mortgage term.
Interest Rates On Mortgages
When you have chosen the right mortgage for you, whether it be a repayment or an
interest only mortgage, you will need to consider the 4 main mortgage rate
Fixed Rate Mortgage
The amount you repay the lender each month can be at a fixed interest rate for a
certain period of time, regardless of the interest rate in the market place. It
is common for lenders to offer rates fixed for a period of 2 to 5 years, but
shorter and longer periods can be found in the market. At the end of the fixed
rate (or ‘benefit’) period the rate will normally convert to the lenders
Standard Variable Rate (SVR).
It is normal for lenders to charge up-front fees in the form of booking and/or
arrangement fees. In addition lenders frequently apply an Early Redemption
Charge (ERC) for fixed rate mortgages. This acts as a ‘lock-in’ making an often
heavy charge for borrowers paying off their mortgage early. Watch out – the ERC
can sometimes last longer than the fixed rate period e.g. a 3 year fixed rate
with a 5 year ERC.
Capped Rate Mortgage
A capped rate mortgage is very similar to a fixed except that if the variable
rate drops below the capped rate, the borrower will make payments based on the
lower variable rate. However should rates increase the payments will be ‘capped’
and will not rise over the capped rate. So as a rough ‘rule of thumb’ a capped
rate is better to have than a fixed if all other factors are equal. Again, as
with fixed rates, up-front charges and ‘lock-ins’ are common.
Discounted Rate Mortgage
The Lender offers a discount on the Standard Variable Rate (SVR) for a specific
period of time. For example, the variable rate may be 5% with a discount of
1.5%. The initial pay rate would therefore be 3.5%. If the variable rate rose to
say, 6%, then the rate payable would rise to 4.5%. As the discount is linked to
the standard variable rate, the borrowers payments will increase, if rates rise
– so there is no certainty in budgeting. However should rates decrease the
borrower will benefit from lower payments.
It is still possible to have up-front charges for discounted products and an
Early Redemption Charge is common.
With discount mortgages borrowers need to watch out for ‘payment shock’. Some
short term discount products offer a ‘deep discount’ e.g. 4% off for 1 year. In
such circumstances the borrower will be facing a significant increase in their
monthly mortgage payment at the end of the discount benefit period.
Variable Rate Mortgage
Borrowers paying the Standard Variable Rate will have their payments increase or
decrease as the lender adjusts the rate in accordance with market conditions.
FEATURES AND OTHER BENEFITS OFFERED WITH MORTGAGES
There are other key features and benefits to be considered when determining the
best mortgage for a prospective borrower.
FLEXIBLE / LIFESTYLE MORTGAGES
CURRENT ACCOUNT MORTGAGE (CAM)
FREE LEGALS OR CONTRIBUTION TOWARDS CONVEYANCING COSTS
FREE VALUATION OR REFUND OF VALUATION FEE
Flexible / Lifestyle Mortgages
A Flexible or ‘lifestyle’ mortgage is designed to let you to make extra
repayments when you have extra money, and to reduce or even skip payments when
necessary. Borrowers will normally have to build up a reserve through
overpayments before being allowed to underpay or skip payments. The main benefit
of flexible mortgages is that many schemes are offered on a Daily or Monthly
Interest Calculation basis (sometimes referred to as ‘daily rest’ or ‘monthly
rest’). Until the arrival of flexible mortgages most, if not all, UK lenders
were charging interest on an annual basis which meant that borrowers making
over-payments were not getting the benefit straight away because it could be a
year before the capital was reduced by the over-payment. Whereas, on a mortgage
where the interest is being calculated on a daily basis, any over-payment
reduces the mortgage balance immediately hence the borrower will be charged less
interest from the next day. Without going into detail to explain this feature
the up-shot is that over-paying the mortgage on a monthly or regular basis, even
by a relatively small amount, will reduce your mortgage term by years (hence
Many flexible mortgages come without any Early Redemption Charge so the borrower
is not ‘locked-in’ to any particular lender. In addition the interest rate
charged is often lower than the usual Standard Variable Rates charged by the
other more ‘traditional’ mortgage lenders.
The flexible mortgage concept was imported from Australia so occasionally you
may hear them referred to as ‘Aussie style mortgages’.
Current Account Mortgage (CAM)
A flexible mortgage linked to a current account. These mortgages take the
benefits of the flexible mortgage and use the funds held in the current account
to offset the interest e.g. on a particular day a borrower has a mortgage
balance of £50,000 and has £2,000 held in the current account. The customer is
charged mortgage interest on £48,000 i.e. the mortgage balance minus the
positive balance held in the current account.
Some of the newer entrants into this sector are also linking savings accounts,
credit cards and personal loans into the mix.
For a borrower wanting one home for their finances this is an attractive option.
The Lender, as an incentive, will offer a lump sum of cash once the mortgage has
been taken out. The amount will vary from lender to lender and on the size of
the mortgage. The amounts can range from a flat fee e.g. £200 to a percentage of
the loan e.g. 3% of the loan.
Normally the cashback is offered as a package of benefits e.g. linked with a
discount, but pure cashback products are not uncommon. Mortgages offering a 5 or
even 6% cashback can be found which would mean a borrower taking a £70,000
mortgage would receive £4,200 on completion (at 6%).
As you would expect lenders apply an Early Redemption Charge with cashback
mortgages. Typically a borrower will be locked-in for 5 to 7 years where a
substantial cashback has been paid.
Free Valuation or Refund of Valuation
A free valuation requires no up-front payment from the mortgage applicant
whereas a refund will only be made when and if the mortgage application
completes. Hence an applicant paying for a valuation and then not proceeding due
to, say, a poor valuation, will not have their valuation fee refunded.
A whole range of other benefits can be applied to mortgages including the
significant benefits of no Mortgage Indemnity Charge and no Early Redemption
Charge. See below for more information about these features.
OTHER FEATURES / CONDITIONS AND CHARGES ASSOCIATED WITH MORTGAGES
Early Redemption Charge (sometimes referred to as a ‘redemption penalty’)
Given that the mortgage market is very competitive many mortgages are sold as
‘loss leaders’ i.e. the mortgage has to be held for a number of years before the
lender breaks into profit. As a consequence lenders frequently ‘lock-in’
borrowers by applying Early Redemption Charges for those paying off the mortgage
early. Charges can be significant e.g. 6 months interest or repayment of the
amount of benefit received, be it cashback or reduced interest. The period an
Early Redemption Charge applies can vary. Sometimes it will match the period of
the discount/fix but often it can go beyond the benefit period e.g. a 5 year
discount with a 7 year ERC. This is referred to as a ‘redemption overhang’.
On this subject see ‘No Redemption’ and ‘No Overhang’ below.
Selecting the 'No redemption' option means that the mortgage schemes on screen
will allow you to repay the loan in full at any time without applying an Early
Most mortgage schemes, in return for offering you a lower initial rate, will
require you to stay with that scheme at least for the period of the Discount,
Fix or Cap, and often longer. If you wish to repay the loan in this time, or you
remortgage with another lender, you will have to pay an Early Redemption Charge
which can cost £thousands (6 months interest is common) depending on the lender
With 'No Redemption' mortgages you will not have to pay this redemption fee
(although there may still be other costs such as sealing fees and legal fees.)
As a consequence of not being ‘locked-in’, the rate offered on these schemes
will usually not be as competitive as for mortgages with redemption penalties,
making them most suitable for those who are likely to keep track of current
rates and wish to remortgage quickly if they find a better rate, or those who
may have to repay their loan in the first few years.
Selecting the 'No overhang' option means that the mortgage schemes on screen
will allow you to repay the loan without penalty once the benefit period has
ended i.e. the mortgage does have an Early Redemption Charge but it does not
last longer than the fixed, capped or discount period. This means that a
mortgage with, for example, a discount to 31st January 2006 will have a
redemption charge to either the same date or a date prior to this.
The Early Redemption Charge can represent a significant sum although the amount
will differ between lenders and between products.
With 'No overhang' mortgages you will only have to pay this redemption fee if
you redeem the loan or remortgage whilst you are still subject to the scheme's
special rate. Once you have reverted to paying the lender's Standard Variable
Rate (SVR) you will be able to redeem the loan without penalty (although there
may still be other costs such as sealing fees and legal fees.) As a consequence
of not locking-in the borrower to the lender's SVR, the rate offered on these
schemes will usually not be as competitive as for rates with redemption
overhangs, making them most suitable for those who wish to benefit from a lower
initial rate without needing a very low initial rate, and who are likely to want
to remortgage to another Discount, Fix or Cap once they are no longer benefiting
from the initial rate.
Mortgage Indemnity Charge (sometimes referred to as a High Percentage Lending
For high Loan to Value (LTV) mortgages i.e. where the loan is not much less than
the value of the property, it is common practice for the lender to take out a
form of ‘insurance’ to protect against some or all of the losses incurred if the
property needs to be taken into possession because of serious arrears. It is
common practice for lenders to pass this charge on to the borrower. Depending on
the amount of loan and the LTV the Mortgage Indemnity Guarantee charge can be a
significant cost e.g. a £47,500 mortgage on a purchase price / valuation of
£50,000 would result in a £750 charge on a typical MIG charge of 7.5% on a
normal lending limit of 75% loan to value. Most lenders have a different name
for this charge i.e. it may not appear on the mortgage Offer as Mortgage
Indemnity Charge or High Percentage Lending Fee.
There are some important facts to understand about the mortgage indemnity
charge. It acts as a form of insurance for the lender not the borrower. This
means that the lender can claim part or all of its ‘losses’ incurred
repossessing the property from the insurance company providing the MIG cover.
Note that even after repossession the former borrower will remain liable for any
sums owing (shortfall between selling price and mortgage outstanding plus
arrears, lenders legal costs and any other charges applied to the mortgage) and
can be pursued by the insurance company for payment at a subsequent date.
The amount charged to conduct a valuation of the property on behalf of the
lender. It is important to note that the valuation is carried out on behalf of
the lender – not the mortgage applicants! Frequently lenders include an
administration fee as part of the valuation fee collected to cover the costs of
arranging the valuation. The valuation does not represent a detailed inspection.
For peace of mind it may be appropriate to obtain a ‘Housebuyers Report’ or a
‘Full Structural Survey’. These are more detailed than a lender valuation but
they produced on behalf of the applicant. They are more expensive than the
Booking Fee and Arrangement Fee
Both are up-front fees charges levied at the outset of the mortgage.
A booking fee will normally be required with the application form. A booking fee
is paid to reserve funds on a mortgage product that has limited funds available
e.g. a first-come, first-served fixed rate. Booking fees are often
non-refundable, so if the mortgage applicant cancels the mortgage application
before completion the fee will not be reimbursed.
An arrangement fee is typically charged on completion of the mortgage.
Arrangement fees are common on fixed and capped rate mortgages. Frequently they
can be added to the mortgage hence the fee does not become an ‘out of pocket’
It is necessary to have a solicitor or licensed conveyancer to act on behalf of
the mortgage applicant and the lender in the house purchase or remortgage
transaction. The costs will be greater for house purchase than for remortgage.
It is the role of the solicitor or licensed conveyancer to note ownership of the
property on the title deeds; note the lenders interest in the property; register
with the Land Registry and conduct searches to identify if there may be factors
which could affect the property e.g. coal mining search to check for subsidence;
check to see if there are some planned major road developments going through the
back garden etc.
Lenders will insist that the property is adequately insured, with a suitable
Buildings Insurance Policy, as it represents security against the mortgage debt.
A buildings policy covers against storm damage, fire, flooding etc and relates
to the fabric of the house or flat etc. It is normal for lenders to check that
any policy arranged is adequate and a fee will sometimes be levied to check the
policy, if the borrowers take a policy other than the one sold or recommended by
the lender. In addition, borrowers will need a Contents Policy that provides
cover for the contents, such as carpets, TV’s, furniture etc. Most lenders and
insurance companies offer a combined Buildings and Contents Policy. In the past
some lenders have made their insurance compulsory with some very competitive
mortgage products although this is less common now.
Another form of insurance common in the mortgage industry is a Mortgage Payment
Protection Plan. This policy is designed to offer income protection against
unemployment, sickness and redundancy. This form of insurance has become more
important as the Department of Social Security has steadily withdrawn the
benefits available. This form of insurance is not compulsory.
Another form of insurance is Mortgage Indemnity Guarantee. This is covered
There are a whole series of other fees that some lenders apply in certain
circumstances e.g. arrears, late payment, removing the lenders name from the
Title Deeds at the end of the mortgage. Under the terms of The Mortgage Code of
Practice the lender will, before a mortgage applicant takes a mortgage, provide
a tariff covering the repayment of the mortgage, including charges and
additional interest costs payable in the vent of arrears and will advise of any
other charges for services before or when the service is provided.
If a borrower has a history of poor credit usage then this is described as
Adverse Credit. Poor Credit history can include County Court Judgements(CCJ),
Bankruptcy, Mortgage arrears or any late payments on credit arrangements.
This describes the amount the borrower is behind in his mortgage repayments
schedule. The amount is usually measured in either pounds or months.
A Corporation, Firm or individual who, via a court proceeding, is relieved from
paying all debts once assets have been surrendered to an appointed third party
designated by the court.
County Court Judgements (CCJ)
An adverse ruling by a County Court against a person who has not satisfied their
debt payments with their creditors. Once the ruling has taken place it will be
recorded against the persons credit history and will appear every time a credit
search is done for the next seven years. If a person has a County Court
Judgement against them it will have to be satisfied before they can get a
mortgage. They will also find that the mortgages they can get will be at a
higher interest rate.
Failure of an individual to make payments on a mortgage at the correct time or
to not comply with the mortgage companies requirements.
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