TALKING out a mortgage can be the single largest purchase that most people will ever make and for many it can also be fraught with difficulties. Which lender should you approach? How much interest should you pay? Should you choose a variable or fixed rate mortgage? Should you buy a traditional repayment loan or an endowment/pension mortgage? What are the merits of buying your mortgage through a mortgage broker rather than directly from a bank or building society?
These are some of the most common questions that readers ask about mortgage buying but there are other, more technical issues like the impact of tax relief, compulsory and optional insurances, the merits of bimonthly or weekly repayments or escalating your payments annually to reduce the total interest bill. You should also inquire about penalties that may apply should you default on your repayments.
Fierce competition between the lenders means that buyers no longer need to have saved with an institution to secure a loan, though certain banks and building societies offer interest rate discounts to established customers, in addition to the discounts they offer first time buyers.
This competition has also meant that many costs and charges have been reduced or eliminated, and as the interest rate table, right, shows, interest rates vary only slightly between lenders. But the APR - the annual percentage rate - and the cost per £1,000 vary for many reasons. The APR must reflect all on going charges against the mortgage, but some lenders can subsidise their mortgage books with other lending, others have lower costs or profit ratios. The important question is whether this is a bank or building society that has consistently produced competitive rates or one that seems to keep rates low when economic times generally are good, but is forced to hike them higher than other institutions when business is slack or the economy is struggling.
The first rule for any mortgage buyer, once you have realistically assessed how much you can afford to pay, is to shop around for the best deal. (Don't forget to include the additional monthly cost of mortgage protection and building/contents insurance.)
Aside from comparing the price of the interest charged, you should also ask the institutions on your list for a total estimate of charges and fees associated with the purchase. Many lenders have dropped application and administration fees in the last couple of years, saving about £300 on an average £40-£50,000 mortgage, but you will still end up paying registration and stamp duties, legal and survey fees.
If you decide to use the services of a mortgage broker, make sure any loan recommendation is justified by producing a comparison chart of interest rates, mortgage charges and insurance rates.
The latter is important, because it is through the sale of mortgage protection and building and contents insurance that mortgage brokers earn their remuneration and you should expect to let them organise at least the mortgage protection policy. Avoid dealing with brokers who charge you an upfront fee for their services (in addition to any commission), even if they offer to refund all or part of it.
When you compare interest rates, (always refer to the APR - the lower rate is a sale gimmick) work out the total cost of the loan over the period. A typical £50,000 mortgage, at 7 per cent APR will cost £7.87 per £1,000 borrowed, or £393.30 a month. Multiplied over 20 years and the real cost of the mortgage amounts to £94,392. (A single extra percentage point raises the total to nearly £102,000.)
By working out your total payment you can better appreciate the impact of compound interest over a long loan period and the advantages of (a) seeking out the best interest rate and (b) taking every opportunity to pay off your mortgage sooner. Most of the leading banks and building societies have schemes in place which either allow you to escalate your payments each year, often in line with inflation or your own pay rise. For someone paying £393.30 a month, an annually indexed increase of 2 per cent will cost less than an extra £7.87 a month the next year, just over £8 the year after that, etc. The Impact, however is to wipe off about £20,000 or more from the total interest bill and reduce the repayment period by several years. A lump sum payment off the capital sum borrowed is also highly recommended, especially if you are prepared to maintain your existing monthly repayments rather than opt to lower them.
More and more institutions are also prepared to accommodate customers who wish to pay off their mortgage more frequently than every month. The benefit of a weekly or bimonthly payment method is that by paying slices of capital off faster (interest and capital are paid off with each payment) you avoid a future interest charge on that capital, thus reducing your total interest bill, our experience is that the banks are more willing to accommodate their customers since they have the computer software systems in place already. The building societies, some of which stilt calculate the reduction of interest against the capital balance once a year (against a weekly or daily calculation which the banks use) can be reluctant to set up such payment schedules. However some say the technology is on the way.
Back in the 1980s when marginal rates of income tax were as high as 60 per cent mortgage interest tax relief was a huge incentive to own a property. Even up to three years ago, homeowners could claim their allowable amount of interest paid at the 48 per cent rate. The relief has been clawed back since 1994/95 and this year three quarters of any interest paid (up to the allowable amount) can be claimed at the standard 27 per cent rate and one quarter of the interest paid at a 32.25 per cent tax rate. Next year the tax deduction drops to a flat 27 per cent rate.
The cut in this deduction has been offset by the lower interest rates we are all enjoying, but it will have a more serious impact for anyone with an endowment mortgage. Unlike traditional annuity loans in which both interest and capital are paid each month, an endowment mortgage amounts to interest only being paid over the entire term of the loan. In addition, the borrower takes out a unit linked or with profit life assurance policy. Theoretically the underlying investment fund grows in value each year and at the end of the 20 years is sufficient to pay off the original capital sum and produce a cash surplus.
Because only interest is paid, the endowment mortgage holder, unlike the annuity mortgage holder who will eventually pay more capital than interest every month, enjoys the maximum level of interest relief for each of the 20 years.
Unfortunately, that substantial tax break is being whittled down to just 27 per cent and the tax relief that once applied to the life assurance policy is also gone. The high commission and cost structure of endowment mortgages also means that unit linked ones in particular have proved to be very poor value and many holders have been advised to increase their monthly premiums or be prepared for a fund shortfall upon maturity.
The sale of endowment mortgages has fallen in recent years to only about 6 per cent of all mortgages, but ordinary borrowers should avoid them unless they are keen on linking the security of their private home to stock market investments.
Your lender or mortgage broker will be keen to sell you the necessary insurances, mainly because they earn commission from the sale. As was pointed out in this column recently by actuary Mr Tony Gilhawley, buying your mortgage protection policy as part of the lender's group scheme may work to your disadvantage if you move lenders since the original policy will be cancelled. Your increased age and/or medical condition is likely to lead to a higher premium, or difficulty in achieving cover.
Increasingly popular is the idea of taking out critical illness insurance as part of the mortgage protection policy in order that the loan is paid off not just if you die, but if you fall seriously ill. Premiums are more expensive than conventional mortgage protection, but it can be purchased on a decreasing mortgage value basis. Building insurance, like mortgage protection cover is compulsory, but you are not obliged to take the policy on offer by the lender. Shop around.
