If you are reading this guide you are probably looking forward to buying your own home.  Most people gain a great deal of satisfaction from becoming a homeowner.  But owning a home also brings new financial responsibilities, and you need to think of these.

This guide will help you understand mortgages better and give you an insight in to the number of options available to you.

Definitions

The parties involved in a mortgage are as follows:

The Mortgagor: the individual borrower who transfers his property to the lender for the duration of the loan;

The Mortgagee: the lender (bank, building society or other institution) who has an interest in the property for the duration of the loan.

Mortgage repayment systems

There are two basic methods of repaying a mortgage loan: a repayment mortgage (sometimes also known as a capital and interest mortgage); and an interest only mortgage.

Repayment mortgages

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 outstanding balance decreases throughout the term.

Interest only mortgages

With this type of mortgage, each mortgage payment is only used to pay off interest. At the same time, the borrower takes out an alternative ‘repayment vehicle’ (method of paying off the mortgage) such as an ISA, pension plan or endowment policy. More information on endowments, ISA’s and Pension plans are set out 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.

Endowment

This is 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. Recently slated 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 policies 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 paid off.

ISA

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 ISA’s complexity it is only for the financially sophisticated or borrowers taking advice from a suitably qualified financial adviser.

Pension plan

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 financial adviser.

Mortgage interest options

Fixed rate mortgage

With a fixed rate mortgage the monthly repayment amount is fixed for a specified period irrespective of changes to the Bank of England’s base rate or the lenders standard variable rate.
Fixed rate mortgage schemes generally last two to five years, although longer terms are available. At the end of the fixed rate the interest rate reverts to the lenders standard variable rate. A fee called an early redemption penalty would apply if you chose to cancel your fixed rate mortgage within the fixed rate period.

Variable rate mortgage

A variable rate mortgage is based on the lenders standard variable rate.
The lenders standard variable rate is generally affected by movement within the Bank of England’s base rate. Standard variable rates vary from lender to lender but are typically 1.5%– 3.5% above the bank of England base rate.  The standard variable rate is not guaranteed to rise and fall by the same rate that the bank of England base rate changes by. If you require this guarantee than a Tracker mortgage rate may be more suitable for you.

Capped rate mortgage

A capped mortgage is similar to a fixed rate in that it will not rise above a pre-set rate, known as the cap.  However if the lenders standard variable falls below the capped rate your rate will fall in line with it. If the lenders variable rate rises above the capped rate your rate will not rise above the capped rate.

Discounted variable rate mortgage

A Discounted Variable Rate Mortgage has an interest rate where a discount is applied to the lenders standard variable rate for a set period. As the lenders standard variable rate moves up or down the discounted rate moves up or down by the same amount.  Discounted rate mortgages are often offered for a set period of time usually two years, though some mortgage lenders now offer discounted rates up to 3 and 5 years.

Tracker rate mortgage

Tracker rate mortgage schemes follow movement in the Bank of England base rate at an agreed differential.  The Tracker rate mortgage is available for a fixed period or the life time of the loan. The most common tracker rate period is 2 years, though mortgage lenders now offer 3 year, 5 year and even 10 year track rate mortgages.  If the tracker rate is for a set period of time the mortgage will revert to the lenders standard variable rate at the end of the tracker rate period.

Flexible rate mortgage

Flexible rate mortgage schemes allow you to overpay and underpay without redemption penalties being charged. You can tailor your current financial situation to the mortgage payments that you make. When you have spare cash you can overpay and if necessary you can underpay, skip a mortgage payment or even borrow money against the capital repaid.
Not all flexible mortgages are the same. Some will restrict how much you can overpay during a set period, others will only allow minimum amounts and some will allow a maximum amount per month.  Restrictions can also apply to borrowing against the capital already repaid. In fact, some mortgages labelled as flexible do not allow you to borrow any money against your mortgage. If borrowing is permitted you should check how easy it is to access the cash you require.

Offset mortgage

Offset mortgages allow you to put all your money in one place - from your mortgage and loans to your savings and current account, giving you the flexibility to live your life differently. With an offset mortgage you get the best of both worlds - the flexibility and value that comes with putting your money in one place and the security of being able to see and manage your finances any way you like.

Libor mortgage

Libor mortgage, like the majority of mortgages on the market track a rate. Unlike the majority of mortgages that track the Bank of England base rate, Libor mortgage track the London Inter Bank Rate. Most LIBOR mortgages track three month LIBOR.
Most LIBOR mortgages have a three-monthly rate review they are variable rate deals but are not subject to change as often as those based on a lender’s SVR or the Bank of England base rate.

Buy to let mortgages

Although the FSA regulate the way the majority of mortgages are sold, in most cases they don’t regulate buy-to-let mortgages. This means you may have less protection if things go wrong with a buy-to-let mortgage. Buying a property to let is a long-term investment which you hope will generate an income from rents and a capital gain when you sell the property. There is no guarantee that you’ll make a profit on your investment.