How much can you afford for your mortgage?

Homebuyers have to make their money go further than ever these days. First-time buyers have to make a huge leap for their future to get onto the first rung of the property ladder. The Council of Mortgage Lenders (CML) has reported that new buyers and movers have to dig deeper than they’ve had to before to buy the house they want.

Even though there has been a recent cooling of the housing market, prices are at an all-time high and have risen very quickly in the past few years. This means that on average first-time buyers are having to borrow an unprecedented 3.33 times their pre-tax earnings to buy their home. And on top of that, thanks to the four recent Bank of England base rate rises, mortgage interest payments now account for an average of 19% of the pre-tax income of first-time buyers. This is at its highest since 1991. They’re not alone, as home movers are in the same situation.

This is a dangerous scenario in itself, but holds further warning signs to be aware of.

It is useful to know how the size of your loan compares with your income. There are some lenders out there who will lend you more than the standard three times your income – up to five, six or seven times your income, but that is not advisable. Quite simply, the more you borrow, the more risk you are taking on. IT may be feasible to borrow up to four times your pre-tax income, but no further, no matter how desirable a bigger, better house may be.

You also need to consider what percentage of the purchase price the loan will make up. Or, to put it another way, what will your deposit be? Any depsoit is better than no deposit. Ten percent is good, twenty-five percent is excellent, but even five percent is a start point. If you have no deposit, you own none of your property; your lender owns it all at the beginning. That will hopefully change later, when the house become more valuable than the outstanding loan. Having paid a deposit also gives you some leeway should house prices fall. This will give you a chance to avoid the trap of negative equity, in which your loan is worth more than your house. It is best to avoid 100% mortgages if possible – again, no matter how tempting they may appear. There are even some mortgages at over 100% – up to 125%, but to take one of these out is to start from a negative equity standpoint stratight away, so it is a bad idea.

What about the difference between a repayment mortgage and an interest-only mortgage? The repayments on a repayment mortgage will always be higher than those for an interest-only mortgage. That is because you are paying some of the capital with a repayment mortgage as you go. On a repayment mortgage, a £150,000 loan over 25 years at an interest rate of 6% would cost you £966.45 a month. The same figures for an interest-only mortgage would result in monthly repayments of £750 a month. But with a repayment mortgage, at the end of the 25 years, you will own your home. With an interest-only mortgage, at the end of 25 years, you will still owe your original loan. Thus, in those 25 years you need to save enough to pay back that loan. This is what endowment policies were for and they were popular in the 80s and early 90s when sold as great vehicles to save enough to pay back your home loan – and have a chunk of money left over besides. They haven’t quite worked out that way. Even so, the monetary difference between a repayment mortgage and an interest only mortgage should be used wisely to ensure that you can pay back that loan.

It is useful to understand how much of your take-home pay is spent on your mortgage. The CML figure quotes a percentage mortgage interest of pre-tax income (which is 19%, as mentioned above). But with taxes having risen in recent years, this figure can’t tell the whole story. The CML figure also only looks at interest, and we’ve just discussed making provision to pay off the original loan. So more realistic figure would be to consider the proportion of a repayment mortgage (or interest-only mortgage plus endowment or savings policies) of your take-home pay. For some, it is possible for this figure be as high as 50%, but a more satisfactory figure would be 33%.

With interest rates having risen by a full one percentage point over the last year, it is easy to see that some people have been badly affected by a rise in the mortgage repayments. Consider making a future budget to build in a 1% or even 2% rise in your interest rates over the next few years. What can you really afford in those circumstances?

Many people these days have to rely on the support of their parents to get them started with their first home, maybe with a loan for the deposit. It is wise to borrow this money with full agreements in place, including a fair rate of interest. Don’t forget they need money to live on too – especially when they come to retire.