Fact 22. What is a Mortgage?

Their function as security for lenders, types, implications for buyers, steps in applying and completion

A mortgage is a crucial financial tool for most people buying property, allowing them to borrow a substantial sum of money to complete the purchase. At its core, a mortgage is a secured loan where the property being bought serves as security for the lender. This means that if the borrower fails to keep up with repayments, the lender can take possession of the property and sell it to recover the outstanding loan amount.

Understanding how mortgages work, the different types available, their function as security, and the practical steps involved in applying and completing a mortgage can help buyers make informed decisions and navigate the property purchase process smoothly.

Functions of Mortgages as Security for Lenders

When a lender agrees to provide a mortgage, they take a legal charge over the property. This charge acts as a form of security, giving the lender certain rights in respect of the property, primarily the ability to repossess and sell it if repayments are not made.

Legal security reduces the lender’s risk: Because the property is collateral, the lender has a direct asset they can claim to recoup their money if the borrower defaults.

Priority in repayment: In the event of repossession and sale, the lender holding the mortgage charge is usually first in line to receive repayment from the sale proceeds before other creditors.

Encourages borrower responsibility: Borrowers are incentivized to keep up repayments as failure can lead to losing their home.

Mortgage types (legal vs equitable): The most secure form is a legal mortgage, where ownership of the property is formally transferred to the lender until the debt is cleared. 

Equitable mortgages are less formal and usually apply when the legal mortgage’s formalities are not met but protection is still granted in equity.

There is a wide variety of mortgage types, designed to cater to different buyer needs and financial circumstances. Understanding the main types helps buyers choose the best fit for their situation.

Repayment Mortgage: The borrower repays both the original loan amount (capital) and the interest over the mortgage term in monthly payments. At the end of the term, the mortgage is fully paid off.

Interest-Only Mortgage: The borrower pays only the interest each month, and the capital is repaid as a lump sum at the end of the mortgage term. This requires a separate savings plan or investment to cover the capital repayment.

Fixed-Rate Mortgage: The interest rate remains fixed for a set period (often 2 to 5 years), providing predictable monthly payments.

Variable-Rate Mortgage: Interest rates can fluctuate based on a benchmark or lender’s standard rate, meaning payments can increase or decrease.

Tracker Mortgage: A type of variable mortgage that tracks a specific rate, often the Bank of England base rate, plus a fixed percentage.

Offset Mortgage: Links the mortgage to a savings account. Savings balances offset the mortgage amount, reducing interest charged.

Buy-to-Let Mortgage: Designed specifically for landlords purchasing rental properties, with different criteria and often higher rates.

Second Mortgage/Secured Loan: An additional loan secured against a property already mortgaged.

Implications for Buyers

Taking out a mortgage has several implications prospective buyers should consider carefully.

Affordability Checks: Lenders conduct thorough affordability assessments considering income, outgoings, and potential interest rate rises to ensure borrowers can meet repayments.

Legal Documentation: The mortgage deed is a legal document signed by the borrower giving the lender security over the property.

Impact on Ownership: Under a legal mortgage, the lender technically owns the property until the mortgage is fully repaid, although the borrower has the right to occupy and use the property.

Costs Beyond Principal and Interest: Buyers should budget for other mortgage-related costs such as arrangement fees, valuation fees, legal fees, and sometimes early repayment charges.

Risk of Repossession: Failure to keep up with payments can lead to repossession and loss of the home.

Impact on Future Financial Flexibility: Mortgages commit borrowers to long-term repayments, affecting their ability to borrow elsewhere.

Steps in Applying for a Mortgage and Completion

The mortgage application and completion process involves several key stages, each important to successful property purchase.

Mortgage Application

Initial Research: Compare mortgage deals, considering rates, terms, and fees.

Affordability Assessment: Provide financial details to the lender, including income, expenses, and credit history.

Mortgage Agreement in Principle (AIP): A preliminary indication from a lender on how much they might lend based on initial information.

Formal Application: Submit full documentation for underwriting including proof of identity, income, bank statements, credit checks, and details of the property.

Valuation Survey: The lender will commission a valuation to ensure the property’s value adequately covers the loan amount.

Mortgage Offer: If approved, the lender issues a formal mortgage offer detailing terms and conditions.

Legal Conveyancing and Mortgage Completion

Instruction to Solicitor/Conveyancer: The buyer’s legal representative is instructed to handle the property transfer and liaise with the lender.

Searches and Enquiries: Local authority and other searches are conducted to check for potential issues affecting the property.

Contract Exchange: The legally binding contract is exchanged confirming the buyer’s commitment to purchase.

Mortgage Deed Signing: The borrower signs the mortgage deed giving the lender security.

Completion Day: The lender transfers funds to the buyer’s solicitor, who then pays the seller. The buyer receives the keys and ownership transfers.

Additional Considerations

Remortgaging: When borrowers choose to switch mortgage providers or adjust their mortgage, often to better terms or equity release.

Early Repayment Charges: Fees payable if the mortgage is repaid before the agreed term.

Interest Rate Changes: Variable rate mortgages carry the risk of payments increasing if interest rates rise.

Insurance Requirements: Many lenders require buildings insurance as a condition of mortgage approval and throughout the mortgage term.

Mortgage Portability: Some agreements allow the mortgage to be transferred to a new property if moving.