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Mortgages

A residential mortgage is perhaps the biggest financial commitment most people will ever take in their lives and yet many people do so without conducting any research into the market place.

There are a number of factors to consider when contemplating taking out a mortgage, the following text is designed to give you a brief insight into the considerations that should be taken into account before approaching a lender for a mortgage advance.




How much can I borrow?

Mortgages
This is generally based upon the amount you earn. Most Banks and Building Societies will offer you up to 3.25 x a single income. Some will offer more but normally up to a maximum of 4 x your income.

Joint incomes can be dealt with in two ways, either 2.75 x your joint income. Another alternative is 3 x the main income, then adding a single multiple of the additional income on top. Existing borrowings such as 'Hire Purchase' arrangements will reduce the amount of mortgage that is available to you.

It is important that you only borrow an amount which you truly believe you would be able to service without causing you financial embarrassment as this may result in your property being repossessed should you fail to keep up the payments.



What types of mortgage are there?

Mortgages
There are two main types of mortgage: Capital and Interest and Interest Only.

Capital and Interest

Otherwise known as Repayment Mortgages. The loan is gradually repaid over the term with a high proportion of each monthly payment in the early years consisting of interest.

The lender will ordinarily require you to take additional Life Assurance to repay the loan in the event of your death.

This type of mortgage has the advantage of giving the borrower the absolute certainty of having the loan cleared at the end of the term, provided they are able to maintain their monthly repayments, but has the disadvantage that if the borrower chooses to move and increase their borrowing in the early years, they are more likely to have to extend the term of the loan.

Interest Only

Interest is payable on the whole amount of the loan. The payment of the capital is deferred until the end of the mortgage term where it must be paid in full. How you choose to repay the loan at the end of the term is normally up to you. The most common method in recent years has been the endowment, however there are a number of other options available.



What repayment vehicles are there for interest only mortgages

Mortgages
It is normally required that the borrower take out some form of savings scheme in order to be able to meet the payment of the capital at the end of the term. There are a number of plans available, which are predominantly used for this purpose:

Endowment plans
Individual savings accounts (ISA)
Personal pension plans

star The borrower must meet any shortfalls on maturity.

Endowment plans

This type of plan has two functions of providing an investment element designed to repay the mortgage on maturity, alongside life cover to pay off the loan in the event of the borrower's death during the mortgage term.

The modern endowment plan is more flexible than its predecessors and is generally calculated using very cautious investment rates of return.

However, recent bad publicity has made this type of mortgage virtually a thing of the past for new borrowers.

Individual savings accounts (ISA)

The ISA is purely a tax efficient savings vehicle in which one can build up a tax-free lump sum, which could be used to repay a mortgage. The premiums are usually invested into unit-linked funds similar to the unit-linked endowment plan.

However, there are two very significant differences between these. Firstly, monies invested within the ISA are allowed to grow free of taxation, therefore creating a greater potential for growth. The second major difference is that the ISA does not have any life cover attached to the plan, and therefore the plan holder would be required to purchase alternative cover at an additional cost.

As the name suggests, an ISA can only be invested into by an individual and cannot be set up on a joint life basis.

There are also limits as to how much you can pay into an Individual Savings Account. ISA's allow up to £7,000 in the current tax year to be invested tax efficiently. There are other limits as to what types of investments you may hold and in what quantities, but this is a complex issue and it is probably beyond the scope of this "brief" guide to go into them all.

This type of plan is very flexible and should only be considered by people who are very disciplined about their finances. If the temptation to "dip in" to your savings is too strong you may have to do some catching up!

Personal pension plans

The plan is designed primarily to build up a fund, which will in turn provide the plan holder with sufficient capital in order to purchase an income in retirement. However, this plan can also be used as a mortgage repayment vehicle.

The mechanics of the pension mortgage are:
At retirement it is possible to take 25% of the accumulated personal pension fund excluding benefits from protected rights as tax-free cash. Lenders will accept this lump sum as a means of mortgage repayment. Again to ensure that the loan is repaid in the event of death prior to retirement, it is necessary to effect separate life cover, which may take the form of either level term assurance or pension linked term assurance.

Given that only 25% of the accumulated pension fund can be taken as tax-free cash and used for loan repayment, contributions to a pension linked mortgage will need to be larger than to the other repayment vehicles mentioned above.

The borrower will not be able to draw his or her tax-free cash before the age of 50.



Fixed interest rate, variable interest rate, discounted interest rate or capped interest rate?


There are a number of different interest schemes available:

Fixed interest rate
Variable interest rate
Discounted interest rate
Capped interest rate

Fixed interest rate

The rate of interest payable is fixed for a set period, after which the mortgage will revert to the lender's variable base rate.

This type protects the borrower from the effects of interest rate rises during the fixed rate term, which can be beneficial to those who wish to be in complete control of their outgoings during the early years of their mortgage. However, it must be borne in mind that should the lender's variable rate fall below that of the fixed rate, the borrower would be at a disadvantage.

Variable interest rate

This is as it says variable and may rise or fall from month to month and is closely linked to the Bank of England Base Rate.

Discounted interest rate

This is where the lender discounts the variable rate by a percentage for a chosen period, after which the mortgage will revert to the lender's standard variable base rate. For example, if the discount were 1% and the variable rate 6.7% the borrower would pay 5.7%. Again the variable rate is subject to fluctuation and therefore the rate that the borrower actually pays will also be variable, but the amount of discount remains the same.

Capped interest rate

The rate of interest is capped at a certain rate, again, for a predetermined period, which means the rate will not go above that at which it is capped. In this type, the borrower pays the prevailing variable rate but the interest rate is guaranteed not to go above the rate at which it has been capped. In other words, you have the best of both worlds. If interest rates rise, your monthly payments will remain level, and yet if they fall below the capped rate, you will pay less.



What about redemption penalties and compulsory products?

Mortgages
Redemption penalities
Compulsory products
Accident, sickness and unemployment cover
Mortgage indemnity guarantee premiums


Redemption penalties

It is very important for a prospective purchaser to realize that the lowest interest rate does not always represent the best deal. You should also take into account the fact that you may well be tied into a lender for a period of time after the special rate has ended.

Compulsory products

Another consideration is whether or not a specific deal requires you to take out an insurance policy supplied by the lender, as these may well be more expensive than if you had shopped around for your own policy.

Accident, sickness and unemployment cover

This is, generally speaking, not mandatory. However, you need to be aware that should you be unable to work for any length of time, you will not receive any assistance from the state for the first nine months.

Mortgage indemnity guarantee premiums

If you are borrowing over 75% of the purchase price, some lenders will ask you to pay a Mortgage Indemnity Guarantee Premium.

This is a one off payment, which protects the lender against you not paying the mortgage and them having to sell the property for less than the amount owed. It does not protect the borrower in any way.

Not all lenders charge for this.



How can a financial adviser help me?

Mortgages
Rather than rushing to your nearest high street bank or building society and then accepting the first offer they give you, you should consider all options that are available to you when planning your future finance matters.

A financial adviser can give you impartial, expert advice and help you to make an infomed decision about obtaining the best mortgage for you.

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