The basics: what is a mortgage and how does it work?

You know the word 'mortgage', but what does getting one actually entail, how does it work and how do you get approved to borrow that much money?
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Kate Hughes14 November 2017

You’ve found your ideal new home. Now comes the small matter of paying for it. That's where the mortgage comes in.

So, what is a mortgage?

In the simplest terms, a mortgage is a type of loan you can take out to buy land or property.

The lender — usually a bank or building society — takes the title of the property until you have paid off the loan and charges interest on the money.

The homebuyer pays off the interest and sometimes a portion of the orignal loan itself each month.

A bank or building society will lend you the money to pay for your home 

Why do I need a mortgage?

Property is likely to be the most expensive purchase you will ever make. Unless your lottery numbers have come up or you’re very, very lucky, you probably won’t have the money lying around to buy a house (known as being a ‘cash buyer’).

The good news, particularly for first time buyers, is that the rate of price growth in London is dropping — down from five per cent in the first quarter of 2017 to only 1.2 per cent between April and June according to date from one of the largest UK mortgage providers, Nationwide.

The bad news is that the average London property is still 56 per cent more expensive than it was just before the financial crisis.

With the average London home now £482,000, according to the most recent Land Registry figures, the chances are you’ll need to borrow a significant amount of money to plug the yawning chasm between your savings and the property price tag.

But how much you can afford, how you borrow it and how you repay it are big decisions that could affect your finances for years, maybe even the rest of your life. So before you start measuring up new sofas, you need to get the money in place.

What is a deposit and how much do I need?

Lloyds Bank estimates that the average first time buyer property in London is around £410,000. In some areas, such as Brent, a first home comes in at more than 12 times the gross average annual salary. But you’ll need to stump up a decent chunk of the money yourself before being able to borrow the rest.

In an ideal world you’d have saved 25 per cent of the value of the property you hope to secure — a cool £100,000 and change — with a home loan covering the remaining 75 per cent in order to be able to pick from the best deals available.

In an ideal world, you'll have saved 25 per cent of the value of the property you're hoping to buy
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The loan you need to cover the shortfall between what you scraped together in savings and the value of the property is called the loan-to-value (LTV).

After the financial crisis, whose roots were in the affordability (or otherwise) of home loans and which exposed major weaknesses in UK lending practices, 95 per cent and 100 per cent LTV mortgages largely disappeared.

They are now starting to re-emerge, but the general rule of thumb is that the greater the LTV you need, the more expensive it will be because your circumstances are considered more risky.

How does a mortgage work?

All commercial borrowing operates on essentially the same basis – that you pay back what you owe, plus a little in return for the lender taking the risk to stump up the money you need. This is calculated as an annual interest rate – a percentage of the amount you’ve borrowed charged every year.

Right now, the Bank of England base interest rate – the key measure used to calculate mortgage interest rates – is currently at an historic low rate of 0.25 per cent, but there are indicators that this could soon begin to rise again

The Bank of England base interest rate is used to calculate mortgage interest rates
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When looking for a mortgage, you’ll often see both the rate of interest offered on a particular loan and the ‘APR’. This is the Annual Percentage Rate, which illustrates the general cost of borrowing money for comparison and reflects not only the interest rate, but also brokers' fees and other charges you’ll need to pay to secure the loan.

Sharia compliant alternatives, usually known as home purchase plans, are usually based upon the Islamic financial principles of Diminishing Musharaka or co-ownership and leasing or Ijara, under which the bank, building society or other provider buys the property and becomes the legal owner.

They will agree to sell you the property at the end of a fixed period for the same price they paid. In the meantime you take out a lease on the property, paying rent to the lender as well as proportion of the purchase cost to eventually buy them out. You can still sell the property whenever you wish.