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Understanding mortgages
Understanding mortgages

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1.1 The property in question and the importance of ‘loan-to-value’

In addition to undertaking the credit, affordability and stress tests, your lender will want details of the property you want to buy.

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Figure 2

This is because most mortgages are ‘secured’ on the value of the property or land the mortgage has been used to buy. This means that if the borrower fails to make the required mortgage repayments, the bank can repossess the property and sell it to recover the money originally lent.

Three things your lender will want to know about the property are:

  • Are you buying a freehold or leasehold property? The difference between the two is that leaseholders do not own the land on which their property is built and only own the property for the term of the lease. Many lenders are unwilling to lend on leasehold properties, particularly where the residual term of the lease is short (70 years or less). This is because such properties may become difficult to sell unless the lease is extended. Note that owners of leasehold properties also incur certain property related costs including maintenance costs (to cover, for example, repairs to the exterior of buildings, particularly when living in a block of flats) and ground rent – a fee paid to the owner of the freehold land on which the leasehold property has been built.
  • Are you buying a property to live in (your ‘prime’ residence) or to rent out (‘buy-to-let’)? For the latter, lenders will usually charge a higher mortgage rate.
  • Is there anything about the property that could make it risky to provide a mortgage for? For example, is it a very old property, or does it have an unusual construction (e.g. built with straw rather than bricks)? Is the property in an unusual location (e.g. above a shop, which may result in issues about access and responsibilities for maintenance)?

Before agreeing to a mortgage, the lender will then get a valuation of the property you want to buy. For most lenders the maximum mortgage they will provide is 95% of the property’s value – or 95% ‘loan-to-value’ (LTV). This is provided that the size of this mortgage does not exceed the maximum the lender is prepared to advance you under the affordability test.

So, for a property costing £200,000, a 95% LTV mortgage would enable you to borrow £190,000 (£200,000 x 95%) leaving you to provide the other £10,000.

The interest rate charged on your mortgage is usually linked to the loan-to-value (LTV). Lower LTVs attract (slightly) lower mortgage interest rates. So it may well make sense to take action to reduce the LTV of your mortgage.

Since lenders tend not to provide 100% LTV mortgages, there is usually a need to use other funds to supplement the mortgage in order to meet the agreed price for purchasing the property. For first-time buyers these could come from using the proceeds from a Help-to-Buy ISA or a Lifetime ISA (LISA).

Activity 1 Cutting the mortgage LTV

Timing: Allow approximately 5 minutes

What can I do to reduce the LTV on my mortgage?

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Pushing down the LTV – a particular challenge for first-time buyers – means finding other sources of money to help fund your purchase. This reduces the size of the mortgage you’ll need. Some options include drawing on your savings or perhaps seeking help from your friends or family (for example the so-called ‘Bank of Mum & Dad’). Your lender will, in any case, need details of the other funds that you use to supplement the mortgage to buy a property. If you do use the ‘Bank of Mum & Dad’ – or similar sources of funds – the providers will need to confirm in writing that such money is a gift. Without this the lender may assume the money is a loan and include it in the affordability testing (with the risk that this will end up cutting the size of the mortgage they will advance to you).

Over time you may move on to a new home (and therefore a new mortgage). Keeping down the LTV will then become easier. This is because the general trend in house prices for decades has been upwards. So when you sell your first home – particularly if you have lived in it for several years – it is likely (but not definite) that you will receive more than you paid for it. This money or ‘equity’ that you extract from the property sale can then be used as the deposit on your next property, thereby helping to keep down the LTV of the new mortgage. In fact you may be able to lower your LTV without moving home by simply repaying your existing mortgage after a number of years and taking out a new mortgage (known as ‘remortgaging’).

Why do lenders charge lower mortgage interest rates on lower LTV mortgages?

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The banks charge lower interest rates on lower LTV mortgages because more of the house value has been paid for, thereby reducing the risk of losing money on the mortgage provided. If they have to repossess a property and sell it during a period of falling house prices, there is less risk of losing money if the original LTV was 60% than if it was 95%.

OK – you’ve (hopefully!) now been approved a mortgage to complete your property purchase. But which type of mortgage product should you go for?