taking out a mortgage is an important step in life, especially when you need money to buy your first home. in this article, we explore different types of mortgages, their advantages and associated risks.
When it comes to personal finance, few decisions carry as much weight as taking out a mortgage.
Since last year’s so-called 'mortgage crisis' erupted, rising interest rates and unemployment forced property owners to cut or even suspend their mortgage payments, paving the way for a worrying decrease in mortgage lending all over Britain.
Within this rather troublesome scenario, it becomes extremely important for both prospective and actual property owners to understand all the risks associated with loans.
Mortgage Risks in a Nutshell
Mortgages are a common means for individuals and families to purchase properties, offering the opportunity to spread the cost of homeownership over time.
However, like any financial transaction, mortgages come with inherent risks.
For borrowers, these risks can manifest in various forms, such as interest rate fluctuations, economic downturns, or changes in personal financial circumstances.
This is the reason why taking out a mortgage needs to be an informed and well-pondered initiative, considering all the potential factors before making a final decision.
One of the crucial risk factors to consider is the Loan-to-Value ratio (LTV).
Loan-to-Value (LTV) and Mortgage Risks
This ratio represents the amount of the mortgage loan compared to the appraised value of the property.
For instance, if a property is valued at £500,000 and the borrower takes out a mortgage of £400,000, the LTV ratio would be 80% (£400,000 divided by £500,000).
LTV ratios play a significant role in determining the level of risk associated with a loan. Generally, higher LTV ratios indicate greater risk for both borrowers and lenders.
Loan-to-Value: What Do Borrowers risk?
High LTV ratios mean borrowers have less equity in their homes.
This condition becomes especially significant in case of a housing market downturn or a decrease in property values.
At that point, borrowers with high LTV mortgages may find themselves in a state of negative equity.
Negative equity takes place when the outstanding mortgage balance exceeds the property's total value.
Negative equity can severely limit borrowers' options to sell or refinance their homes, effectively locking them with the property without much space for agency.
Loan-to-Value: What do Lenders Risk?
An excessively high LTV ratio should not only worry borrowers.
In fact, lenders can be caught in the crossfire too.
More specifically, lenders face increased risk with higher LTV ratios because they have less collateral securing the loan.
In situations of default, lenders may struggle to recover the full amount owed if the property's value has depreciated below the outstanding loan balance.
Consequently, lenders often impose stricter terms and higher interest rates when facing higher LTV ratios to mitigate their risk exposure.
Credit Score and Mortgage Risks
Another decisive factor playing a key role in lending decisions is credit score, which is usually monitored through credit checks.
Depending on the borrower’s individual credit score, the interest rates, loan terms and other eligibility requirements will change – sometimes even drastically.
Credit Score and Interest Rates
Lenders use credit scores to assess borrowers' creditworthiness and likelihood of repayment. A higher credit score indicates a lower risk of default, making borrowers more attractive candidates for approval.
Conversely, lower credit scores may lead to loan rejection or less favourable terms.
Typically, borrowers with higher credit scores are typically offered lower interest rates, translating to lower monthly repayments over the loan term and to an overall decreased cost of borrowing.
Credit Score and loan-to-value ratio
Credit scores also play a role in determining other key loan terms, such as the loan-to-value ratio, down payment requirements, and mortgage insurance premiums.
Prospective property owners with higher credit scores may qualify for loans with lower LTV ratios or smaller down payments, while those with lower scores usually face stricter terms or higher upfront costs.
Which Mortgage is right for me?
Another important factor to carefully evaluate all the risks associated with mortgages is – obviously – one’s own personal situation.
Indeed, there are a wide variety of mortgage types to choose from when trying to buy a property and, therefore, it becomes vital to make the right choice.
Let’s now see three different types – each suited to different situations.
First-Time Homeowners: Shared Ownership Mortgages
Shared ownership is a UK government-backed scheme designed to help individuals and families buy their first home.
While other support programs, such as help-to-buy, are no longer available, shared ownership schemes can indeed prove useful to overcome financial challenges and it represents one of the best mortgages for first-time buyers.
The functioning of shared ownership is rather straightforward: in a nutshell, you effectively buy only a share of the property - between 10% and 75% - while the rest remains in the hand of the property developer or of a housing association.
Then, you will start repaying your mortgages as usual, plus a ‘rent’ for the portion you do not own (usually lower than 4% of the rented share).
Although there are some additional limitations, when looking at the choice of property to purchase and the maximum household income to qualify for example, shared ownership can be a useful tool for aspiring homeowners who do not have large sums of money to put down on deposit
Yet, there are also important risks to consider.
If you fail to timely repay your mortgage, your house may be repossessed.
Click here to know more about shared ownership.
Landlords: Buy-to-Let Mortgages
Buy-to-let is a type of mortgage scheme especially popular among landlords and property investors.
To be eligible for a buy-to-let, you will have to be at least 21 years old, and you will be required not to live in the property as well.
Buy-to-let mortgages can be jointly taken out by up to three people (if you are not a company).
Higher deposits and interest rates are usually required and the amount you can borrow is mostly dependent on the rental income you expect to collect.
While buy-to-let have experienced huge popularity in the past, the recent economic downturn impacting the UK housing market has made them less appealing to investors and lenders alike.
Indeed, landlords and property investors can be more likely than homeowners to default if they do not find the loan terms affordable anymore.
Click here to know more about buy-to-let.
Low credit Score: Guarantor Mortgages
Another type of mortgage is the so-called guarantor mortgage.
In this kind of agreement, the presence or absence of a guarantor heavily affects the associated risks.
Indeed, these types of mortgages involve a third party, usually a family member or close relative, who agrees to take responsibility for the mortgage payments if the borrower defaults.
Guarantor mortgages can be beneficial for borrowers with limited credit history or lower incomes, as the guarantor's financial stability provides additional security for the lender. This may result in lower interest rates or looser eligibility criteria, particularly in case you have less-than-ideal credit scores.
However, guarantor mortgages also pose huge risks to the guarantor, who may face financial repercussions if the borrower fails to meet their mortgage obligations.
How to Mitigate Mortgage Risks?
As we have seen, it is simply not possible to find a zero-risk mortgage.
Yet, while mortgage risks are an integral part of property ownership, it is always possible to take steps to mitigate the risk factor.
Firstly, saving for a higher deposit is useful to reduce the LTV ratio, thereby lowering both borrower and lender risk and secure a more favourable mortgage deal.
Another best practice to follow is considering mortgage insurance, such as private mortgage insurance (PMI) or mortgage indemnity insurance (MII). Mortgage insurance can partially protect lenders in cases of default.
It is to be noted, anyway, that this adds an additional cost for borrowers.
Lastly, it is always important to monitor property values. Housing market trends and prices’ fluctuations are an important indicator to help you assess potential risks and make an informed decision.
Property Fraud and Mortgages
Having finally managed to acquire a property by resorting to a mortgage, any unforeseen event might drastically shift the balance between repayment and default - both for homeowners and landlords.
Such is the case of property fraud.
Should you fall victim to the proliferation of property fraudsters in the UK housing market, the risks involved can be immense.
When fraudsters manage to perform property fraud and identity theft, they are then free to try and sell your properties, or to take out another mortgage against it without your knowledge.
This can result in abrupt and enormous financial damages for both borrowers and lenders.
Title Guardian offers a simple solution to always be vigilant, reducing the risks of becoming a victim of property fraud to virtually zero.
Thanks to our digital monitoring system, we can proactively identify any suspicious movements around your properties or home, enabling you to act quickly before fraudsters.
Explore our services or take a look at our pricing option to start protecting yourself right now.
