Housing, first-time-buyers and mortgages are all over the news recently. But if you’re new to the conversation, the terminology can be confusing. This article tries to explain the basics of mortgages for those just starting to think about them…
What is a Mortgage?
A mortgage is a loan secured on a property. Being ‘secured’ is important - it means that despite you owning the property the bank has a ‘charge’ against it and can repossess it if you stop repaying. This isn’t quick or easy to do, and happens much less than you think, but it is possible. Taking security makes mortgage lending less risky for the bank and is why mortgage rates are cheaper than other loans (mortgages typically 2-4%, versus car loans 6-10% and credit cards up to 12-18%), even if still higher in Ireland than many other countries.
Getting a Mortgage
Since mortgages are usually big (average €225k for first-time-buyers in 2020) and for a long time (often 25 - 35 years), banks are careful about making them. There are umpteen things they analyse, but it all basically boils down to answering two questions:
Can You Make the Repayments
Nobody will lend if they don’t think you will pay it back! So the bank will weigh up your income against the repayments and your other out-goings. They’ll also do a ‘stress-test’ to see how you would cope if interest rates went up in the future. You might be surprised how much of this analysis relies on basic ‘rules-of-thumb’:
Loan to Income - in most cases, a mortgage will be limited to a maximum of 3.5 times your income (or both incomes if applying as a couple). This restriction was imposed by the Central Bank after the last crash and is intended to prevent a repeat.
Stress-Test - this analysis considers repayments if interest rates rose 2%. That may not sound like much, but it will have a big impact on your repayments - see Why Mortgage Rates Matter So Much.
30% Guideline - this one is a little less rigid, but there’s a school-of-thought that says its not wise in the long run for someone to spend more than roughly 30% of their income on housing.
If Something Goes Wrong, Will the Bank get its Money Back
If you tick all the above boxes you’re probably a good candidate for a mortgage right now. But it’s impossible to predict how you’ll behave over the next 25-odd years. People can lose a job, get sick, or just stop paying on time. None of these are good for the bank, so they build in a buffer. (One could also pass away, but this is covered by a separate, mandatory, insurance policy)
The buffer is actually quite simple - the bank won’t lend you the full value of the property. This way, if anything happens and they need to repossess it, they can be pretty sure they will be able to sell it for enough to pay off the mortgage. This is the concept of loan-to-value (LTV), and so by lending only 80-90% there is an in-built buffer of 10-20%. This also ensures you have skin-in-the-game since it is your own money that will disappear first in this scenario.
And that’s the underlying principles of mortgage lending - just two questions and a lot less complicated than it may seem.
I’m planning future posts on mortgages including (1) deciding between fixed and variable interest rates, (2) options for coming up with that 10-20% deposit, and (3) other costs to be aware of when buying a property. I’d be flattered if you would consider subscribing, and will do my best to bring you helpful, insight posts into the future.
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