May 3, 2025
What Is A Mortgage And Its Types? Explain How They Work with Examples
By : Ellie Brown
To buy a residential property, you must take out a mortgage. One lacks the financial flexibility to buy one with a lump sum. It is challenging amid the rising costs and basic monthly expenses. Thus, splitting the cost of a home purchase seems a wise decision. It helps you buy the property without compromising on other short or medium-term goals. The blog is a detailed guide on mortgages, types of mortgages, and how they work. Read ahead if you want to climb up the property ladder as a first-time home buyer.
What is a mortgage?
A mortgage is a long-term loan used to buy a piece of land, residential or commercial property. The borrower agrees to pay the property’s price in instalments over a specific period. It is a secured loan where the property you want to buy acts as collateral. The creditor may keep the documents related to the property unless you repay the complete amount. Failure in loan payment or default may lead to asset seizure. The creditor may legally claim the mortgaged property as his own.
It is a long-term agreement of 10-25 years. Therefore, the process involves meeting specific eligibility criteria. Each mortgage provider sets credit score and deposit requirements according to their standards. Moreover, you may have multiple credit scores from different credit agencies. The preference depends on the specific mortgage provider.
Thus, one must explore the mortgage and compare the basic quotes. It helps you fetch the one that you qualify for. Usually, an individual needs to have a good credit score with consistent income. You need to provide at least 10% (minimum) of the new property’s price as a deposit on the loan. You can provide more if you can without affecting your finances.
What are the 4 types of mortgages for first-time home buyers?
There are 4 main types of mortgages that you can find in the UK for the first first-time buyers. Choosing the right financial types directly impacts your financial planning. The type of mortgage you choose impacts your cash flow and the timeline by which you can repay your mortgage. Thus, knowing the mortgage types and how they work with examples in the UK marketplace will help you choose the right one.
1.Fixed-rate mortgage:
A fixed fixed-rate mortgage is one of the most common mortgages in the UK. In this, the interest rates and monthly payments remain fixed until the loan term. It is regardless of the economic change. Thus, it allows you to budget for the repayments comfortably. The fixed-rate you pay depends on the cash deposit you can put down.
It also depends on the equity you have in your property. It is also known as the loan-to-value ratio. An LTV of 90% means that you can get 90% of the property price as a mortgage amount. If you share low equity in your property, you are likely to pay more interest on the loan.
Example- The current base rate in England is 4.5%. Typically, the fixed-rate mortgage is calculated by multiplying the borrowing amount by the interest rate. If you borrow £50000 at an interest rate of 8%, your answer is £4000. You can generally get the mortgage for 2-5 years.
Credit assessment: Mortgage providers conduct credit checks on every mortgage type, fixed or variable. These checks could be soft and hard to determine the creditworthiness. It helps them analyse the current income, employment history, pending payments, and monthly expenses. Accordingly, they offer you a mortgage amount.
How does the fixed-rate mortgage work?
When you apply for a fixed-rate mortgage, your terms remain the same for 5, 10, or 15 years. This means your monthly instalments will remain fixed regardless of economic changes. However, when the deal ends, the interest rate changes to the lender’s standard variable rate. It is unless you get a new mortgage.
Who is it ideal for?
A fixed-rate mortgage is ideal for someone looking for security and flexibility when budgeting for payments. It is ideal for first-time home buyers who don’t want to deal with shifting repayments. Homeowners seeking a good mortgage rate can also check one.
2. Variable-rate mortgage
Unlike the fixed rate mortgage, variable rate mortgage payments may change with a change in the economic interest rates. If the interest rates fall, the monthly payments also decrease. Similarly, when interest rates increase, the monthly payments also increase. There are different types of variable-rate mortgages. Here, we take an example of the Follow-on-tracker rate that’s common with first-time borrowers.
For example, the Follow-on-Tracker rate tracks the Bank of England base rate. It is generally 2.49% higher than the base rate. If the base rate shifts from 6.0% to 6.5%, the follow-on tracker rate will also change from 2.49% to 2.99%.
How does a variable-rate mortgage work?
In this mortgage type, the interest rate may change with a change in the economy. Thus, you may either face low monthly payments or high depending on the Bank of England base rate. Individuals may benefit from the fall in interest rates. It reduces their monthly liabilities and helps them save more. Moreover, if you improve your credit score with regular payments over a long period with constant payments, you may fetch more affordable rates.
Who is it ideal for?
A variable-rate mortgage is ideal for someone confident about the probability that the rate of interest will fall.
3. Discount-rate mortgage
A discount rate mortgage is when you pay a reduced rate than the lender’s standard variable rate. The discount amount is generally fixed. The reduction applies to the SVR that’s decreased or increased by the loan provider.
Example
If the SVR (Standard Variable Rate) is at 4.5% and you are eligible for a straight 1.5% discount, you only pay 3% on the mortgage rate. Similarly, if the mortgage provider decreases the SVR to 4%, your mortgage rate will be 2.5%. Here is a detailed example of a discount rate mortgage.
You take £2,00,000 on the mortgage for a 30-year term. Here is what your agreement may look like:
- Discount rate- 4.5%
- Discount mortgage repayment (monthly)- £1,013
- Standard Variable Rate- 6.5%
- Standard Variable payment- £1,264
How does the discount rate mortgage work?
Discount-rate mortgages are available for just the introductory term. The discount applies to the interest and the amount you pay monthly. Afterwards, the mortgage shifts to SVR. However, it increases the opportunity for a higher discount before the introductory period ends. Thus, it grants you time to explore and fetch the best discounted-rate mortgage.
Meanwhile, check your credit report to understand the changes. It will help you understand whether you can manage the payments after the introductory period ends. Identify the debts to settle and pay. It will help you create flexibility for other payments.
Who is it ideal for?
First-time home buyers looking for cheaper rates during an introductory period may benefit from this. However, you must be able to pay more after the introductory period ends.
4. Standard Variable rate mortgage (SVR)
A standard variable-rate mortgage works on the rate set by the mortgage lender. It is not linked directly with the supreme authority Bank of England’s base rate. In this, the authority lies with the lender to increase or decrease the mortgage rate. You thus pay less per month, depending on the lender’s decision. The payments constantly shift and make it difficult to budget for.
Alternatively, SVR grants the freedom to overpay and pay the dues on time. It helps you save money on interest payments. Moreover, you can leave the agreement in between without penalties. Analyse the possibilities of remortgaging as interest rates fall. Explore and apply for loans that meet your budget and affordability. Otherwise, you may pay high interest on an SVR mortgage.
Example of Standard Variable Mortgage (SVR)
For example, if you take out a two-year SVR and don’t remortgage before the period ends, you will move to the lender’s SVR.
How does a Standard Variable Mortgage work?
An SVR mortgage is where the lender sets the interest rate. The mortgage customers get one after the initial deal ends. If the SVR is high, you pay high monthly payments and interest. Similarly, low AVR helps you pay less on mortgage payments. However, you may walk free from the agreement and take on another without paying a penalty. For example, if your finances don’t align with the changed SVR, you may leave the agreement.
Who is it ideal for?
It is ideal for homeowners who would like to explore better and affordable terms. You may not want to stick with one agreement. Instead, want the flexibility to shift anytime you want.
Bottom line
These are some popular types of mortgages and examples that may help you choose the best. Opt for a fixed-rate mortgage if you want to budget comfortably for the payments. Alternatively, check a variable-rate mortgage to benefit from low interest rates.
However, it may work either way to make the payments costly. Identify whether a Standard variable-rate mortgage may work for you. It grants the freedom to switch or move out of the agreement if the lender’s SVR seems costly or does not suit the budget.