FOOL'S EYE VIEW
How Mortgages Work

By Jane Mack (TMFJane)
March 2, 2004

A few days ago, a young friend of mine asked me how mortgages worked and what sort he should go for. He's a first-time buyer and, as he has just managed to beg a sizeable deposit from his parents, he is now in a position to start looking for a home to buy.

It's easy when you've had a mortgage for several years to assume that everyone knows how a mortgage works but if you've never had to think about it before it must be quite confusing especially when terms like 'interest only' and 'offsetting' are bandied around. So here's how I explained it to him:

First of all, a mortgage is simply a loan - albeit a rather large one - which is secured on the property you're buying. So, if you fail to make your mortgage payments, the lender can sell the house in order to get their money back.

Because it's a very large loan, the period over which you pay it back is usually quite lengthy because otherwise the payments you make each would be huge. You also have to pay interest on the loan and, with mortgages, the interest is 'front-loaded'.

This means that the lender will take the amount you want to borrow (let's say £100,000), the length of time you want to borrow it for (usually 25 years) and, depending on the interest rate they want to charge, calculate the interest due over that period. Then they'll add it all together. So, over the course of the mortgage term. you'll have to pay back not just the original £100,000 but also all the interest due as well. 

The two main types of mortgage work as follows:

Repayment Mortgage

With a repayment mortgage your monthly payments will be put towards both the interest and the original loan. At the start most of it will go towards the interest with only a tiny amount paying off the capital. But as time goes on and the amount of interest due gets smaller and smaller, more of your monthly payment will go towards paying off the capital.

This type of mortgage has the benefit of certainty in that, when you get to the end of your 25 years, you will have paid back absolutely everything you owe and the house will belong to you.

Interest-Only Mortgage

With an interest-only mortgage, the total amount you owe is split into two parts - the interest and the original loan. Each month you pay your mortgage lender only the interest you owe so your monthly payments will be lower than they would be for a repayment mortgage.

The lender ignores the original amount of the loan (the £100,000) until the end of the 25 years when they'll ask for it back in a lump sum. It is, therefore, up to you to make sure that at the end of the mortgage term you've got £100,000 in the bank so you can pay them back in full. Usually, people will pay an additional sum each month into some form of investment product that is designed to achieve the required amount by the end of the 25 years.

As you might imagine, an interest-only mortgage has more risk in that the investment product might not grow enough to pay off the loan. Many endowment policy holders are facing this situation at the moment. However, it has the potential to grow even more than necessary - maybe even by enough to enable you to pay off the lump sum early or to have a bit of a profit at the end of the 25 years.

Whether or not you opt for a repayment or interest only mortgage, therefore, depends entirely on your attitude to risk. With the former you can be certain that you will pay off the mortgage while with the latter you are effectively taking a gamble that you'll be able to.

Offset/Current Account Mortgages

These types of mortgages are comparatively new to the UK and they work by allowing you to use any savings you've got against the mortgage balance. So, instead of you getting interest on your savings, the capital sum is used to reduce the amount of the mortgage thus saving you interest on the mortgage. As mortgage rates are usually higher than savings rates, you're better off saving yourself the interest on the former rather than receiving interest on the latter.

This method also saves you tax because you'd usually have to pay tax on any savings interest whereas you don't if you're using them to offset the mortgage. And they're flexible too in that the savings you use to offset against the mortgage effectively represent overpayments which means you can always 'borrow them back' if you need to. Because of all these benefits, these types of mortgages tend to be more expensive than repayment or interest-only.

Anyway, to answer my friend's question about what sort of mortgage he should go for, I suggested he opt for a simple repayment in the first instance - certainly until he got used to being a homeowner and had lived with interest rate changes for a while. He can always remortgage to a different type when he's decided he has the confidence to do so.

Find out more: Mortgages; Offset Mortgages; Is An Offset Mortgage For You?