Mortgages: The ultimate guide

What is a mortgage?

The word “Mortgage” comes from a French origin meaning “death pledge” – which isn’t great marketing, and does rather make you wonder how they got to be so popular.

The answer is “because you can buy a house by only having to pay about 25% of its price” – which is a much more compelling sales pitch.

This 25% or so is called a deposit, and represents your equity in the property. The rest is a debt that you owe to the lender, and must pay back by the end of the mortgage term.

If the value of the property goes up, good news for you: that increases your equity, while the amount you owe remains the same.

But if it goes down, the debt remains the same and you lose some of your equity. If it goes down far enough, the property can end up being worth less than the amount you owe: this is what it means to be in negative equity.

The loan is secured against the property – which basically means that if you fall behind with payments, the lender can repossess the property and sell it to get their money back. Because they’re lending you substantially less than the property is worth, they’re confident that they’ll be able to get their money back even if you default – which is why mortgage rates are a lot lower than credit cards or other “unsecured” borrowing.

Mortgages can typically run for anything from 10 to 30 years, but the most common mortgage term is 25 years. That doesn’t mean you’re stuck with the same lender or product for that long: that’s just the maximum, and there’s nothing to stop you from moving to another lender after a couple of years and starting a new 25 year term with them.

What can you use a mortgage for?

You can use a mortgage for practically anything, as long as a few circumstances are in place:

• It must be habitable – so there’s a kitchen and bathroom, and somebody could live there in its present state
• It must be of “standard construction” – so it’s not made of wood or concrete, and it’s not a mobile home or anything like that
• You must want the loan to run for at least a couple of years

Each lender will have their own criteria about what they will and won’t lend on. Some are very picky about what they’ll accept (like only in certain areas, or above a certain value), whereas others will consider almost anything. So you can’t be sure that one particular lender will lend on any given property, but it’s likely that at least one lender will do as long as it meets the criteria above.

Getting the right type of mortgage

It’s not just the property itself that counts: it’s also what you’re using the property for.

Say that you’ve got a 4-bedroom house. There are lots of different uses you could put this property to:

• A buy-to-let for a working family
• A buy-to-let for tenants on benefits
• A buy-to-let for students
• An HMO (renting it out by the room)
• Short-term accommodation for holidaymakers

Again, it’s possible to get a mortgage for any of these uses from some lender – but any given lender might say “yes” or “no” to different uses.

So when you’re considering your mortgage options, you need to consider both what the property is and what you’ll be using it for. If you take out the wrong type of mortgage (for example, a normal buy-to-let mortgage for an HMO), when the lender finds out they’re within their rights to demand immediate repayment and to refuse to lend to you again.

Loan to value

As we’ve seen, a lender will give you a loan equal to a certain percentage of the property’s value. Unimaginatively, this is known as the “loan to value” – or LTV.

On a buy-to-let mortgage, some lenders go as high as 85% LTV, but the most common level is 75%. That means that if you’re buying a property for £100,000, you’ll put in £25,000 and the lender will contribute the remaining £75,000.

You can, of course, always borrow less than the maximum – and interest rates tend to be lower for loans that represent a smaller percentage of the property’s value.

Rental cover

As well as knowing what the property’s worth, the lender will need to know that the rent is high enough to cover the mortgage payments – even if interest rates increase.

As a minimum, the rent must be equal to at least:

• 125% of the mortgage payment
• If the interest rate was at least 5.5%

Some lenders will apply tougher tests – like 140% of the mortgage payment. For some types of lending (like loans to companies, and for fixed terms of at least five years), tests might be looser. On the whole though, this is pretty typical.

But what does it mean?

So in order to borrow £100,000 using these criteria, your monthly rent needs to be at least £572.91. If it’s higher, great – but if it’s lower, the total amount you can borrow will be reduced.

(If you’re a portfolio landlord – meaning you own at least four properties with mortgages on them – lenders must also look these types of figures across your whole portfolio when deciding whether to make a loan.)

Finding the upper limit

The amount you can borrow will be set by the lower of these two factors: LTV and rental cover.

So, say you’re buying a property for £120,000, it will rent for £700, and you want to borrow £100,000. As we’ve just seen, in order to borrow £100,000 the rent needs to be higher than £572 – which it is.

But the maximum LTV for our imaginary lender is 75%. 75% of £120,000 is £90,000 – so that’s the maximum you could borrow.

In other situations, the opposite will be true. Say you’re buying a property for £150,000 which will rent for £550 and you want to borrow £100,000. The LTV is 66%, which is fine. But the rent of £550 isn’t enough to support the full borrowing of £100,000: in this case, the maximum you could borrow would be £96,000.

As we’ve already seen, when it comes to product selection you need to:

• Make sure it’s appropriate for the intended property use
• Decide what LTV to borrow
• Check that the rental cover is high enough to justify the borrowing

But that’s just the start: there are lots of other factors that go into the mix…

Interest only v repayment

In the figures so far, I’ve based everything around an interest only mortgage.

As the name suggests, you just pay the interest on the borrowed money every month – and at the end of the loan term, you still owe the full amount outstanding.

This is in contrast to what you’ll likely have on your own home, which is a capital repayment mortgage. With one of these, you pay off a chunk of the borrowed money every month as well as the interest, so by the end of the term the property is 100% yours.

You can use a capital repayment mortgage for a buy-to-let property, but in my opinion, interest only is always better – even if you actually fully intend to pay off the whole balance from savings at the end of the term.

You don’t have to agree, but a lot of people don’t understand the reasons and think it’s far more risky than it is. That’s why I’ve written a whole post about interest-only and repayment mortgages here.

Fixed v variable rates

Even though full mortgage term tends to be around 25 years, a lot can change over that time – so most mortgage products will only offer specific rates for the first two, three or five years.

The initial rate you’re offered will usually be fixed, a tracker, or variable.

A fixed rate is – as the name suggests – fixed. If you sign up to a fixed rate deal of 4.3% interest for three years, your interest rate will definitely be 4.3% for the next three years – whatever happens to the base rate.

A tracker mortgage will be quoted as a certain percentage above the Bank of England base rate – and track it as it rises and falls. For example, you might get a tracker of 2% above base rate for three years. If the base rate starts at 1%, you start by paying 3%. Then, if the base rate goes up to 1.5% after a year, you pay 3.5%.

(A lot of very lucky people took out generous “lifetime tracker” when the base rate was 5%, priced at 0.5% above bank base rate for the entire mortgage term. When it fell rapidly to 0.5%, they were paying mortgage rates of only 1% and have been ever since!)

A small number of tracker mortgages track LIBOR rather than the Bank of England base rate.

A variable mortgage isn’t really an introductory deal at all: basically, it’s whatever the lender wants it to be at any given time. It tends to move up and down when the base rate changes, but won’t necessarily: the lender doesn’t have to pass on any cuts, and can raise it whenever they want to.

When the initial term (of usually two, three or five years) ends, you’ll move to the lender’s “standard variable rate” (SVR) – which is exactly the same as a variable rate mortgage.

The initial rates you’re offered tend to be better than the SVR. For that reason, it’s common for people to remortgage when their initial deal ends so they can switch to a new deal with a different lender and get a fixed rate or a tracker again.

So, which type of mortgage should you take out?

There’s a lot to be said for fixed rate products, because you have the certainty of knowing what your payments will be until the fixed period ends. However, if interest rates go down, you won’t benefit.

The longer the fixed period, the higher the rate will be – because the lender needs to “price in” the possibility of interest rates going up.

With a tracker product, you’re taking on the risk of rates increasing: if they do, you’ll need to budget for paying more. But if they fall, your mortgage payments will decrease.

So the decision really comes down to two things:

• How much you value certainty
• What you think is likely to happen to interest rates

Fees

It’s not as simple as just choosing the product that has the lowest interest rate – because they also have different fees associated with them.

The main fee you’ll need to pay is a “product fee”, “arrangement fee”, or “facility fee” – all just different words for the same thing.

This can be either a percentage of the loan – say, 0.5% or 1% of the amount borrowed – or a fixed figure like £999. Sometimes, you’ll find a product with no arrangement fee because the lender is especially keen to do business.

Often, these fees can be added onto the loan to be paid at the end rather than having to actually pay them out of pocket at the start. That makes it seem like they don’t make that much of a difference – but they really do.

For example, imagine you’re borrowing £100,000 for a fixed rate period of two years:

• Product A has a fixed rate of 3.25% and a fee of £1000
• Product B has a fixed rate of 3.5% and no fee

Over two years, Product B is actually £500 cheaper overall – even though the interest rate is higher.

You’ll also usually have to pay a valuation fee, to pay for the lender’s surveyor to go out and value the property for mortgage purposes. Lenders charge different valuation fees, and sometimes you’ll find products that have no valuation fee at all (because the lender pays for it).

Other smaller fees might apply too, such as a redemption fee of a couple of hundred pounds to cover the paperwork of releasing their charge over the property when you repay.

And just when you thought that was quite enough in the way of fees, don’t forget your legal fees. If you’re buying a property and taking out a mortgage on it at the same time, your solicitor will only charge a bit extra for dealing with the mortgage element. If you’re taking out a mortgage separately (on a property you already own), your legal fees will be higher – because they’ll need to make a lot of the checks that would be necessary if you were buying the property.

Early repayment and overpayment

You might think that lenders would be happy to have you pay the money back early – compared to the alternative of you paying it back late or not at all!

But actually, if you take out a loan with an initial “deal” for the first years (such as a 3-year fixed rate product), there will usually be a hefty penalty for paying the loan back before the end of the three years. This can be as high as 5% of the total amount borrowed – which makes it prohibitively expensive to switch during this period.

The same goes for overpayments: there’s often a certain amount you’re allowed to “overpay” by each year, with penalties for exceeding it.

How long should you fix for?

This leads us to an interesting question: how long should you lock into your mortgage for?

Say you take out a 1-year fixed rate or tracker mortgage. The benefit is that if a better deal comes along, you can switch after a year without any penalties. The downside is that you’ll then go onto the lender’s SVR, which is unlikely to be a very good rate: and when you switch away from that, you’ll have to pay all those fees all over again.

At the other end of the scale, say you take out a 5-year fixed rate or tracker deal. This means you get to (effectively) spread out the arrangement fee over a larger number of years, reducing your overall cost. The downside is that if either a better deal comes along, you want to refinance for a higher amount, or you need to sell the property, you’ll potentially have to pay a large early repayment fee.

Restrictions

As we saw earlier, you need to have a suitable mortgage for what you’re planning to use the property for.

For example, many products insist that you use the property for a single family who aren’t claiming housing benefit. Even if the interest rates and fees are fantastic, if you’re letting to multiple unrelated tenants or a family claiming housing benefit, you’ll have to ignore that product.

Summarising product choice

To summarise…choosing a mortgage product is massively complicated. Adding to our list at the start of this section, we’ve now seen that you need to consider:

• Whether it’s appropriate for the property and its intended use
• What LTV to borrow
• Whether to go for interest-only or repayment
• What the interest rate is
• What the fees are
• Whether it’s fixed or a tracker
• How long to fix for

This is why I thoroughly recommend using a mortgage broker. Your odds of picking out the best mortgage by just looking at a “best buy” table are next to none: even if the interest rate looks good, there might be other factors that render it inappropriate or unattractive.

To understand what lenders are looking for, it’s easiest to start by imagining their dream borrower – somebody who:

• Has a full-time non-property job earning good money
• Owns their own home
• Has one investment property already
• Has a squeaky-clean credit file

This type of borrower clearly has some degree of experience (without being over-extended), has a steady source of income elsewhere to service the debt, and has a track record of managing credit.

It’s very possible for someone who doesn’t meet one or more of these criteria to get a mortgage. It’s just that the further you diverge from the “ideal customer”, the more restricted your choice of lenders will be.

Let’s look at a few common scenarios…

Low income

Most lenders like to see that you have some level of non-rental income, and the most common threshold is £25,000. As with all aspects of mortgages though, it varies: some want to see just any income, while others want more than £25,000.

For most lenders, income derived from rents won’t count – but other sources of property income (like managing properties or sourcing deals) will.

Having an income below £25,000 doesn’t mean you can’t get a mortgage, but will seriously restrict your choice of lender.

No residential home

If you don’t own the home you live in, some lenders will suspect that you’re actually buying the property to live in – not to rent out.

It’s fair enough for them to be suspicious and need to reduce the risk of their products being abused, but frustrating because there are lots of perfectly good reasons for not owning your home. A good broker might be able to go some way to explaining the situation.

No existing rental properties

Some products will only be available to “experienced landlords”: a definition that varies, but often means having owned a rental property for six months or a year.

This means that when you’re buying your first rental property, your choice will be more constrained than it will be next time. If you find yourself seriously constrained for some reason, one solution would be to use bridging finance to buy the property and own it for six months before applying. Hey presto – you’re an experienced landlord.

Too many rental properties

In a proper Goldilocks scenario, too few properties is bad but so is too many. Some lenders will restrict either the number of mortgages you can have with them, or the number you can have in total with all lenders.

Self-employed, not employed

Borrowers who are full-time employed are seen as a safer bet than those who are self-employed – which doesn’t quite make sense to me because you could lose your job the day after getting the mortgage and lose 100% of your income, but hey.

Many lenders will want to see at least two years of accounts if you’re self-employed, and sometimes a reference from your accountant.

Living overseas

Getting a mortgage as an expat can be particularly tricky, with a very limited choice of lenders – although the market is opening up.

You can expect fees to be higher because they’ve got more work to do in validating your circumstances and ruling out fraud. Rates will also be higher, to price in the additional risk of it being harder to pursue you personally if you default.

The minimum loan amount can also be higher, because it’s not worth their while doing all that work for just a small loan.

Summarising you factors

Every lender is different, and mortgage criteria change all the time. If you’ve been told that you can’t get a mortgage due to your circumstances, try again with a different broker: I constantly hear from people who were told “no” a couple of times, only to find a broker who had a better understanding of criteria and was able to find something for them.

If you do have a limited choice, the interest rate will be less competitive than if you had the whole of the market open to you – and the loan-to-value ratio they’ll give you might be lower. But if the numbers still add up, that’s OK – especially if you expect your circumstances to change over time to pull you closer to the “ideal”.

Company v personal mortgages

Because of the punitive tax changes for individual landlords taking effect from April 2017, it’s become massively more popular to buy properties within a company.

For this, you’ll need a specific limited company product: you can’t buy within a company using a normal “personal” mortgage. The choice of company mortgages is more restricted, but opening up all the time.

Everything in this article applies equally to limited company and personal mortgages: even the parts about “you”, because your own circumstances are just as relevant in a decision to lend.

It’s a big topic, and I’ve written a whole post about company mortgages here.

Find the right lender and product

If you’re working with a broker, they’ll look at your aims and your circumstances and draw up a shortlist of suitable products. If your circumstances are unusual, they might speak with their contact at each company first to make sure you would be eligible.

They’ll show you an illustration of each product so you can see the rates and fees, and help you make a decision about the best one to go with.

If you’re not using a broker…you probably should.

Get a Decision In Principle (DIP)

A Decision In Principle (DIP) is also known as an Agreement In Principle (AIP), and is confirmation that the lender is likely to lend to you based on the information they have so far. It’s all about you: you don’t even need to have a property in mind to get a DIP.

Your broker will feed in the basic details of your case, and the lender’s system (usually largely automated) will assess them to see if you fit their criteria. A successful DIP doesn’t mean the lender is committed to lend: they’re just saying that they’re likely to, pending a suitable property and verification of what you’ve told them.

Having a DIP can be useful before you go out looking for properties, for two reasons:

• It gives you the confidence that you can in fact get a mortgage
• It demonstrates to agents and vendors that you’re organised and creditworthy

Make a formal application

Once you’ve got a DIP and an offer accepted on a property, you can make a full mortgage application.

Your broker will submit this for you, and the lender might come back with additional questions and requests for evidence. A good broker will preempt any back-and-forth by anticipating what information they’ll ask for, and getting it all from you upfront to avoid delays.

Even if you had a successful DIP, it’s still possible for your application to be refused at this stage – for any reason, including “no obvious reason at all”. Your broker will try to find out why this has happened, so you can decide who to apply to next.

Wait for the valuation

The lender will send their valuer to assess the current market value and rental value of the property. This is an important step, because if the valuation is unsatisfactory the lender might either refuse to lend or reduce their offer.

Frequently, this is a frustrating stage for investors. You’ll be seeing the property in its most positive light, yet the valuer’s incentive is to spot all its faults and be as conservative/negative as possible.

It’s almost impossible to successfully challenge a valuation, even if you think they’ve made mistakes – unless it’s practically to the extent of them having valued the wrong house. Instead, your broker will just need to do their best to find out why so (again) you can decide who to apply to next.

Receive your offer

Once the lender has gone through all your paperwork, made their background checks and got comfortable with the valuation, they’ll (finally) make a formal mortgage offer.

This is a binding commitment to lend, and gives you a certain amount of time (often three or six months) to make use of the funds before the offer expires.

This offer will be copied to your solicitor, who will liaise with the lender as part of the conveyancing process to register their “charge” over the property and draw down the funds.

In time for completion, the lender will send the mortgage funds directly to your solicitor. On completion day they’ll send them to the vendor…and the property is yours!

Timings of the mortgage process

Getting a mortgage isn’t a particularly quick process. Some lenders are faster than others, but it’s safest to allow three months from application to having the funds in your bank. If it’s faster (and it often can be), you’ll be happy – but if it is that slow, you’ll have expected it so it won’t mess up your plans.

As I mentioned, a good broker can really help this process by anticipating any questions and providing all the information upfront. The more back-and-forth, the more drawn out the process will be – but even if you’re super-efficient, there’s plenty of scope for delays beyond your control.

Whether you can get a mortgage depends on both you and the property. If you’re a “typical” borrower with a typical property, you’ll have an enormous amount of choice between products. If the situation is more unusual, you’ll be restricted to fewer products with generally higher rates.

Great though mortgages are, the range of products and complexity of criteria mean it’s almost impossible to pick the right one without it being your full-time job. That’s why I always recommend working with a mortgage broker.