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A guide to mortgages during rising rates

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Mortgages are like any other form of secured loan. We use collateral to secure a large borrowing of money, which we repay with interest applied. However, there are some ways mortgages can deviate from other loans, such as continuously agreeing on new terms throughout the loan term.

Each lender can place its own limitations, but there seem to be some common industry standards. In the UK, it is recommended you place a deposit down that is worth at least 20% of the value of the home. This is to avoid over-leveraging and negative equity, but also because a bigger deposit can bargain you a cheaper interest rate.

Most banks want 10-15% minimum, but in some scenarios (and in other countries) it can be as low as 0%. Another requirement is often income, with most lenders only lending an amount roughly 4.5 times your (joint if buying with a partner) annual income. Unlike most loans, mortgage lenders rarely judge you on your credit score.

Government help to be aware of for first-time buyers

The fairly new government-backed mortgage scheme was introduced to help those struggling to get a sufficient deposit to get on the housing ladder. It targeted first-time buyers and helped facilitate 95% of mortgages. An extension of this scheme is the Help to Buy scheme, in which first-time buyers receive a hefty low-interest loan towards their first deposit.

Another scheme that focuses on first-time buyers is the Lifetime ISA, an ISA in which the government provides a 25% bonus towards everything you deposit as cash. There’s a £4,000 annual limit for contributions (thus a £1,00 annual bonus limit), but within four years, you could essentially have £4,000 extra deposit money for zero risk. Well, the only risk is if you don’t use this money to buy a home or for retirement, as you will be penalised 25% on withdrawals. Check here for more information about the Lifetime ISA.

You will incur a lifetime ISA government withdrawal charge (currently 25%) if you transfer the funds to a different ISA or withdraw the funds before age 60 and you may therefore get back less than you paid into a lifetime ISA.

By saving in a lifetime ISA instead of enrolling in, or contributing to an auto-enrolment pension scheme, occupational pension scheme, or personal pension scheme:


        (i) you may lose the benefit of contributions from your employer (if any) to that scheme; and
        (ii) your current and future entitlement to means tested benefits (if any) may be affected.

Types of Mortgages

There are many, many different types of mortgages. Instead of listing all of them, let’s dig deeper into the ones that are most relevant to the average wealth-building individual.

Repayment mortgage

A repayment mortgage is your standard mortgage: you repay both the principal amount and some interest. Your mortgage amount will decline over time (though, not linearly), and it’s designed for homeowners looking to build equity and eventually live mortgage-free.

Fixed-rate

With a fixed-rate deal, the interest you agree to pay is fixed for a given amount of time (i.e. 5 years). Many people get a 25-year term mortgage, but the fixed-rate agreement is a portion of time within this. This is great for having a fixed budget, so you know what you will pay. You are also protected from any hikes in interest rates, but overpaying often incurs a penalty.

Variable-rate

Variable interest rates are exactly how they sound: no guarantee over what the interest rate will be on your mortgage next year. It can change at any time. This is difficult to budget for, but one upside is they can often be immediately cheaper as they pose less of a risk to banks. You also usually get more freedom to overpay without penalties.

Interest-only mortgage

Again, the clue is in the name with this one. Interest-only mortgages mean that you only pay the interest, so your mortgage remains the same size and will never be paid off - unless you decide to remortgage to a different one. Clearly, your monthly repayments will be cheaper, but it’s often only a short-term solution.

Buy-to-let mortgage

These are landlord mortgages, in which the money is lent to you with the understanding that the home (which is being used as collateral) is being rented out. Here, they will take into account the rent you will receive and are extra careful about the risks involved (i.e. missed rent). The deposit required is usually higher, income minimums may be placed, and the mortgage amount may be limited to what rent you expect to receive. In other words, they’re more expensive and less leveraged, but are often the only choice because many other mortgages do not permit letting.

Some Buy to lets are not regulated by the Financial Conduct Authority.

What rising rates mean for mortgages

When the Central Bank, which controls the flow of money in an economy, increases the base rate, this means that the rate banks are charged increases. Logically, if banks are being charged more, this will be passed onto the bank customers to ensure profits don’t fall.

Since the 2008 subprime mortgage crisis, the UK, US, and most of the world’s central banks have used low base rates to spur on economic growth. Despite being an unthinkable 14% in the late 80s, the base rate was below 1% between 2009 and 2022. Today, it has risen to 1.75% with talks of further increases despite a looming recession. The reason? To combat sky-high inflation.

There’s not much of a time lag between a rise in the central bank’s rate and a rise in mortgage rates. Though of course, those locked into fixed-rate contracts will see no immediate changes.

Mortgage rates today are, at best, 3%. A typical 25-year £200,000 mortgage at 3% means roughly £950 per month repayments. Roughly 50% of that is principal and 50% is interest.

If interest rates were 12%, which they were for most of the 80s, it would mean having ~£2,100 monthly repayments with only 6% of that paying off the principal.

Nobody believes rates will reach these heights again, partly because it would risk another 2008-esque crash. But, it highlights interest rate risk for a homeowner - even small increases can cause cashflow troubles.

3 Mortgage Tips

LTV thresholds can cause spikes in rates

How much leverage you have is an indicator of risk to the bank, with negative equity being their biggest fear because they wouldn’t be able to recoup their money in the event of a repossession.

So, it’s no surprise that your Loan-to-Value (LTV) influences what rate you receive. But, sometimes these thresholds can be very rigid. For example, a 65.5% LTV might be 3.5% interest, but a 64.5% LTV might be 3.2% interest.

This isn’t always the case, but it is worth seeing if you can make a small lump-sum payment in order to significantly reduce your interest rate.

Consider an interest-only mortgage

It’s a fallacy to believe your mortgage debt will remain stagnant because you’re not paying off the principal. This is not true in real terms, because inflation is greater than your interest repayment.

People often say your bank savings are being eaten away by inflation. It’s true, but so is the reverse regarding debt. And so with a 3% mortgage and 8% inflation rate, your mortgage is decreasing by 5% each year in real terms. Suddenly interest-only doesn’t look so stagnant.

So on the whole, you will have lower monthly payments - and some of this freed-up money can be used on other investments, meaning your portfolio is becoming more diverse and away from property.

Get a deal as fast and long as possible

Interest is on the rise. It’s no secret that the Bank of England is more likely to increase the base rate than they are to decrease it.

So, it may not be worth waiting around when it comes to getting a mortgage, but also to lock in a fixed rate to protect yourself from rising rates. A variable-rate mortgage is all the riskier during times of volatility.

Your home may be repossessed if you don’t keep up with repayments on your mortgage.

 

Martin Dudely

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