Mortgage Basics

So you're looking for the perfect mortgage. But how do you choose from the several thousand that are available?

To start with you need to understand the various different types. A mortgage is simply a loan, secured on the value of a property, which you pay back over a given period of time. 'Secured' means that if you don't make payments as you agreed the provider has the right to sell your property in order to recover their money. In reality, events rarely get this far, especially if you contact your provider as soon as you find you are having difficulties.

The usual term of a mortgage is 25 years, but it can be over longer or shorter periods depending on your own circumstances. The initial amount you borrow is called the capital, and there are two main ways of paying this amount off. These are covered below. You also need to pay interest on the capital you borrow -- and there are more options you can choose here but we'll cover these in the next article.

1. Repayment

This is the only way you are going to guarantee that the property is yours at the end of the term - no 'Ands, Ifs or Buts'. What it means is that every time you hand over some dosh, you'll pay off a bit of the interest due and a bit of the capital until the debt is completely and utterly finished. Auf Wiedersehen! Finito.

In the beginning you'll be paying off mostly interest, so if you sell up in the early years you'll find you've hardly paid off any capital at all. But after a few years, you'll be whittling away at bigger and bigger chunks of the capital -- and those regular statements telling you how much you still owe will start to elicit big smiles instead of fearful gulps. Many lenders now offer flexible repayment mortgages too so that you can pay more than the prescribed monthly amount when you can afford to and take 'payment holidays' when you can't.

A repayment mortgage is the surest and safest way to see off the loan. Safe as houses, in fact. It's the route to take if you absolutely, categorically, do not want to risk the roof over your head in any way whatsoever. You borrow the money and you pay it back in instalments -- it's as easy as that.

2. Interest Only

With this type of mortgage, monthly payments to the lender are all interest. You don't pay off any of the capital during the term of the mortgage -- you do it at the end, having made simultaneous monthly payments into some sort of investment fund. So each month you send one batch of money off to the lender, and another batch off to an investment fund.

By the end of the term, if your investments have done their stuff, you should have accrued a nice pile of cash with which to pay off the capital sum of the mortgage, and maybe even a little extra. At least that's the theory. One way of doing this is to buy a low-risk fund, such as an index tracker, and hold it within the tax-protective ISA. When the 25 years are up, you've already paid off the interest, and you simply hand over the relevant sum from your ISA to pay off the capital. Bingo! The house is yours.

Obviously it's important that you're sensible about the amount of money you salt away each month into your investment fund. You may have to agree the basic amount with your lender, but if there's a shortfall at the end of the term, it's your problem not the lender's. They'll just take your house if you can't pay them back! But it does mean that if your investments do well, you may be in a position to pay off the mortgage early or have a lump sum left over to spend on having some fun! The key word is 'may'.

One worrying trend in recent years is the growth in the number of interest-only mortgages where people are making no separate plans to repay the capital element. Instead they're relying on house prices to rise sufficiently so that they will be able to trade down to a smaller property and use the difference to pay off the mortgage. This is an extremely high risk approach in our view and not one we'd recommend.

Assuming you do opt for the interest-only route it's absolutely vital that you monitor the progress of your investments as you may need to increase the amount you put away each month if they aren't growing as quickly as expected. If you don't feel comfortable with this burden then choose the repayment route. Also, bear in mind that if you are on a tight budget you may not have the option of increasing your payments.

And there's more. Because your monthly payments to the mortgage provider only consist of interest they will vary by a larger amount if the rate of interest changes. Try a few numbers in our mortgage calculator and you'll see that interest-only payments rise by a greater amount than repayment ones do when the interest rate rises. If you have a tight budget this is another thing to bear in mind.

Incidentally, it is possible to have a combined repayment/interest-only mortgage, which can be useful for those who want to increase their mortgage or who don't want to risk the whole of it on investing in the stock market.

A few words on endowments

An endowment mortgage is a form of interest-only mortgage. The endowment policy is a combination of savings, investment and life assurance all wrapped up in an insurance policy. The life assurance bit merely ensures that the mortgage is automatically paid off if you suddenly drop dead.

Unfortunately, many endowments are failing to meet expectations, one of the reasons being that their charges are extremely high. The other reason is that investment returns have fallen in recent years. Remember, if this happens with an interest only mortgage, you will probably need to increase the amount you pay into your investment fund. The same is true with endowments. Unfortunately, the policy providers have been rather slow to pass this message on, meaning that many people are getting letters warning that their endowments may not cover their mortgage.

These days there are many instances of compensation for policies that were mis-sold (for example, many people were told that the policies were guaranteed to pay off their mortgage, but this was never the case). In view of their growing unpopularity, very few mortgage lenders now offer them. Good job too! Endowments are inflexible, high cost, underperforming investments and shouldn't be touched with a barge pole in our view.