FOOL'S EYE VIEW
60-Second Guide To Choosing A Mortgage

By James Carlisle
August 21, 2002

In this country we've got the homeowning bug and it makes good sense. After all, if you rent your home then your landlord should be making a profit from you. So why not cut out the middle man and "Be Your Own Landlord?" For most of us, though, that means taking on a whopping great mortgage. It's a big step and not to be taken lightly, but here's a quick guide to what you should be considering.

0:58 What can you borrow?

Traditionally a bank would offer you three times your annual salary or about two and a half times joint incomes for a couple. Currently some banks offer a little more - some offer up to five times your salary or three and a half times for a couple. If you're self-employed or part of your income comes from a bonus or commission then the situation is a little more complex and will vary from lender to lender. There's more about how much you can borrow here.

0.49 But what can you really afford?

What you can borrow and what you can afford are not necessarily the same. The bottom line is that you should be able to pay the interest comfortably for the next 25 years (mortgages usually last for 25 years but you can choose a shorter or longer period if you wish). Only you can say how likely you are to lose your job or how likely you are to get pay rises, but you should take a conservative view of things.

The other part of the equation is interest rates. Mortgage rates are usually 1% to 2% higher than the base rate, which is set each month by the Bank of England. What would you do if they, say, doubled from their current level? You can see what effect this would have on your monthly payments by using the mortgage calculators in our mortgage centre. Whilst sharp increases are unlikely in the short term you need to consider what you'd do if rates increased significantly in a few years' time. There's more about how much mortgage you can afford here.

0.37 Decide how you want to repay the capital

There are basically three choices here. With a 'repayment mortgage', you repay a little bit of capital each month so that it's all gone after 25 years. This is the safest route since you can be sure that the debt will be eventually disappear if you keep up the payments.

The second option is the 'interest-only' mortgage. With these you only pay the interest each month, but put a bit aside (at least corresponding to what you're saving by not paying back the capital) and invest it. The plan is that the investments will be at least enough to repay the capital after 25 years. For this to be the case, the investments will need to make a return (after any tax you may have to pay) that exceeds the interest you're paying on the mortgage. Since you can't be sure how your investments will fare, this involves risk. If you are happy to take the risk, then a cheap index-tracking ISA is probably the first place to look for an investment vehicle.

The other alternative is a flexible mortgage. With these you essentially treat the mortgage debt as a big overdraft and you can choose how quickly you reduce it. So you can swing between the repayment route and the interest-only route as the mood takes you (make sure you pay it all off in the end, though!).

There's more about how to repay the capital on your mortgage here and more about flexible mortgages here.

0:25 How do you want to pay the interest?

The main options are variable-rate (or tracking) mortgages and fixed-rate mortgages. With a variable rate mortgage, you pay the interest rate currently set by your bank or building society. Broadly speaking, this will vary alongside the base rate. 'Tracking' mortgages specify that they will charge you a set percentage above base rates.

With a fixed-rate mortgage, you 'fix' your interest for a number of years into the future. This can make things a bit safer because you know where you stand for the fixed period, but your interest rate might suddenly jump at the end of the fixed period. If interest rates fall more than expected then you'll be kicking yourself until the fixed period expires, because you will most likely have to pay redemption penalties to get out of the deal. There are several other little tweaks that you can get. Capped rates, for example, mean that your interest rate can't go above a certain rate, while it can come down.

Having decided what to go for, you basically want to find the lowest interest rate possible. However, the really low rates may well involve a big hike further down the line. If that's a possibility then you'll want to make sure you're free to move somewhere else when it happens. There's more about choosing how to pay your mortgage interest here.

0:09 Take a big gulp and go shopping

So there it is. You've figured out how much you're happy (or happyish) to borrow and you've decided how to repay the capital and interest. Now take a few moments to reflect on things. You're about to saddle yourself with a large slab of debt. The plan is that you get a nice house or flat into the bargain, but these are of uncertain value.

Are you very confident that you'll be able to make the repayments (and, if necessary, do the investing) to pay the mortgage off? Yes? You sure?? Okay, it's time to go shopping for a mortgage. It's a big 'purchase', though, so be sure to take your time and look around.

More: The Motley Fool's Mortgage Centre.