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What is a mortgage and how does it work?

When you start looking into buying your first home, it can hard to navigate all the terms that are part of the process.

You’re probably aware of mortgages, but they can feel daunting when you’re just starting your home buying journey.

Read on to find out what a mortgage is, how it fits into your buying process and what you’ll need to do.

What is a mortgage?

A mortgage is simply money borrowed from a “lender” (a bank or building society) specifically for buying property.

When you take out a mortgage, you agree to pay the lender a set amount each month which will cover any interest on the loan, and usually pay off some of the money you’ve borrowed too. In this way, you pay the mortgage back to the bank over time.

How do I apply for a mortgage?

Most people use a mortgage broker, sometimes called a mortgage advisor, to find the best deals and apply for a mortgage on their behalf. Some brokers won’t charge you for their services as they’ll get commission from the mortgage lender you use, but some will ask you to pay their fee so it’s worth finding out before you commit to one.

They’ll work out the best deal available for you based on how much deposit you have, how long until you retire (most lenders will want the mortgage repaid before you retire), your income and how much you’re prepared to pay each month.

Once they’ve run their suggestion past you, they can then apply for a “mortgage in principle” for you, which is simply confirmation from the lender that it sounds like you’d be successful if you applied for the mortgage – it’s not legally binding. This should give you a good idea of how much you can spend on your home.

Once you’ve found a property and had an offer accepted, the mortgage broker will then formally apply for the mortgage from the lender.

When you’re applying, you’ll agree how much you plan to pay as a deposit with your lender. A mortgage deposit is usually around 10% of the value of the house, but it can be as low as 5%. Your lender will ask you for some evidence that you can pay this deposit, such as bank statements, but you won’t actually pay it until the day you complete your purchase.

Your mortgage will be for the total cost of the house minus the deposit you put down. So, if you’re buying a property worth £250,000 and you put down a 10% deposit of £25,000, you’ll be paying your lender back the remaining £225,000 over time, plus interest.

When you complete your purchase, you’ll send the money for your deposit to your solicitor, and your mortgage lender will send over the rest of the amount for the house. After that, you’ll officially be a homeowner and you can renovate and decorate to your heart’s content.

How does a mortgage work?

On the day you get your keys, you’ll start repaying your mortgage. Your lender will have sent you a breakdown of how you’ll do this, including the interest you’ll pay.

Generally, you’ll have agreed to repay your mortgage over a set term, for example 30 years. The amount you pay each month will add up to the total amount you borrowed for your mortgage plus interest, so that at the end of the mortgage term you’ll own your home mortgage-free.

The quicker you pay your mortgage off, the less interest you’ll pay overall, but this can mean paying more each month to reduce the amount you owe quicker.

The amount of interest you pay on top of the money you borrow will depend on the borrowing interest rate.

You can agree to a “fixed interest rate”, which means you and your lender agree an interest rate and they guarantee they won’t change it for a set period of time, for example five years. This protects you from interest rates going up, but means you can’t take advantage if interest rates drop. Lenders tend to offer a lower interest rate if you’re happy to agree to a rate for a longer period. You can renegotiate with your lender at the end of the fixed period.

Alternatively, you could choose a “variable interest rate mortgage”, which means that you’ll pay whatever the interest rates currently are. When you take out your mortgage, you might find that this is lower than the rates being offered for fixed interest rates, but if mortgage rates go up then you’ll need to pay more each month so it is more of a gamble.

Your mortgage broker will be able to talk you through your different options and help you decide what’s right for you.

How much is a mortgage?

Your mortgage is the value of the property you’re buying, minus your mortgage deposit. You’ll pay this back, plus interest, over a set period by making monthly repayments.

Your monthly repayments will depend on a few key factors:

  • How much you borrow,
  • What percentage of the property you pay for with your own money, i.e. your mortgage deposit,
  • Your lender’s interest rate,
  • The length of your mortgage term, which is usually between 25 years and 40 years.

When you speak to your mortgage broker, you’ll usually start by discussing how much you can afford each month. They can then use this to work out how much you can borrow without paying more than this, by taking into account the interest rates lenders are currently offering.

Interest rates tend to be lower if you pay for a higher percentage of the property with your mortgage deposit. Again, though, this is something your mortgage broker can discuss with you. They will likely show you how borrowing different amounts and increasing or decreasing your deposit will affect your monthly repayments.

What is an interest-only mortgage?

Interest-only mortgages are a type of mortgage where your monthly payments only cover the interest on your loan, so the amount you owe the bank doesn’t go down.

You’ll therefore pay less each month, but you do still have to pay back the full amount to your lender at the end of the mortgage term.

It’s generally harder to get an interest-only mortgage than a regular repayment mortgage as not all lenders offer this option. Those that do have a strict selection process. In many cases you’ll need to show evidence that you’ll be able to pay off your loan in full at the end of the term.

Can I afford a mortgage?

If you can afford to rent and have a deposit saved up, you can probably afford a mortgage, depending on current interest rates.

Discuss with your mortgage broker how much you can reasonably afford each month and they’ll let you know how much you can probably borrow. It’s then up to you if this is enough to buy a property that you want to live in.

However, buying a home also comes with some upfront costs. If you’d like to move from renting to buying, you’d have to save up for a mortgage deposit, which can be tough to do when you’re renting, but there’s a few options out there to help.

The key difference when you go from renting to owning is that you’ll be paying monthly towards owning your own property, rather than helping your landlord pay off their own mortgage.

It’s worth keeping in mind that if you don’t make your monthly mortgage repayments, the bank could claim your home to pay off the money you owe them. This is called having your home “repossessed”.

If you’d like to know what kind of mortgage you’d be able to afford in your current situation, here’s a handy calculator.

Saving up for a deposit

The biggest challenge for anyone looking to buy their first home is often saving for their mortgage deposit. You might have a good income, no debt and a perfect credit score, but if you don’t have a deposit saved up then you might find it difficult to get a bank to lend you a mortgage.

A good way to save up for a deposit is by opening a lifetime ISA.

A lifetime ISA is an investment account made specifically to help you either buy your first home or save for retirement. You get a 25% government bonus on investments of up to £4,000 a year. So, if you pay £4,000 into a lifetime ISA,you’ll get an extra £1,000 from the government.

The catch is that you can only take money out of your lifetime ISA to buy your first home or after you turn 60, otherwise you’ll have to pay a penalty charge.

If you choose to use your lifetime ISA to buy a home, you still have the option to keep putting money into it to help with your retirement later on, so if you could end up using it for both.

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Got £25 in your current account? If you put it in a lifetime ISA now you'll be taking your first big step towards owning your own home. OneFamily's Lifetime ISA is a stocks and shares product, which means your money is invested in the stock market. While there is good potential for it to therefore grow in the long-term, there is a risk you could lose money.

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