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CASE STUDIES

MORTGAGE CASE STUDY: first time buyers

Judy Brown and Paul Williams

• Judy and Paul are prospective first time buyers. They are getting married shortly and are looking for advice on house purchase. They would like to buy as soon as possible.

• Judy has worked in the Civil Service for 5 years, and currently earns £20,300 per year with no overtime or bonuses. Paul has worked as a technical author for an IT company for the last 4 years. He earns £21,500 per year, with a potential annual addition of £3,000 in bonuses. His bonuses for the last 3 years have been.

  2003 : £2,750; 2002 : £2,500; 2001 : £2,250.

• They have no children. At present Judy lives with her parents. Paul has a flat which he rents for £125 per week. He also has a car loan with a finance company on which he originally borrowed £5,000 and currently owes £3,000. Both have credit cards and owe balances of approximately £1,000. They have no other debts.

• The couple have saved £7,000 between them, which is in a building society account. Judy also has a legacy of £2,000 which will be paid soon.

• They wish to buy a property for about £100,000. They know little about mortgages but make it clear that they intend to shop around for the best deal.

This study is an 'average' scenario of the first-time buyer. Surprisingly, considering such an investment is probably the largest and most important in most people's life, and given the abundance of advice available in books and magazines, mortgage advisers and lenders still find that much of the house buying process remains a mystery to their enquirers. Remember Rule 5P – Proper Preparation Prevents Poor Purchasing!

Some of the basic questions – with some opinions – that Judy and Paul should be asking themselves are as follows:

1. How much will we be able to borrow?

   One 'rule of thumb' formula which is commonly used is to take the whole of the higher income plus half of the lower income and multiply the total by 3. This would give them a loan potential of £76,500.

2. Will we need to provide proof of earnings?

   Yes. Some or all of the following will be needed by the lender: employers' references from both applicants, with P60's as a cross-check to prove income; possibly a landlord's reference or sight of a rent book to prove reliability in paying; credit check on both applicants; sight of bank statements as cross reference to income and expenditure; check of own institution's records on existing business relationships, if any, and to check on how such relationships have been managed.

3. Will we need a deposit? What else?

   Deposit usually of 5% to 10%, although there is no upper restrictions. Requirements vary with lenders. Say 5% £5,500 Valuation fee; assume: £200 Legal costs and other outlay associated with the purchase. Assume £1,000 Stamp duty £1,100 Higher lending charges £150 one off payment (depending on policy and amount of loan compared to property valuations)

4. What is the 'higher lending charge' mentioned above?

   It is an insurance intended to protect the lender in the event of loss on high percentage advances.

   Payment of this does not reduce the obligation to pay - if claimed upon, the insurance company can sue the borrowers for what has been paid out.

   One way of approaching this with the customers is to emphasise that it does enable the financial institution to provide a higher percentage advance, thereby reducing the need for a larger deposit.

5. Do we have to use the method of repayment suggested by the lender? What repayment methods should we consider?

   Borrowers have an absolute right to choose whether to take a capital and interest mortgage or an interest only mortgage. Forcing them to do otherwise would contravene 'best advice' principles.

   The lender WILL insist on property insurance to protect the security for the loan.

   The pros and cons of an interest only mortgage are:

   Potential for a tax free lump sum at the end of the term but this will not always be the case. If the supporting investment policy is a unit-linked insurance policy, life cover is part of the contract. Expert fund management, although all long term investments are speculative to some extent, so returns are not guaranteed. The product may not pay off the mortgage if investment returns are disappointing. If ISA linked, life cover has to be bought separately. May not suit the 'risk averse' i.e. those who do not like the thought of the fund they are building to repay their mortgage fluctuating in value with the movement in investment generally.

   Early surrender can result in getting less back than capital invested.

   Advantages of a repayment mortgage:

   Guaranteed repayment of loan at end of period. More and more capital is repaid as the period advances. Because it is not linked to investment products with a finite item, restructuring the loan on a different basis e.g. longer term, is more easily accomplished.

   Disadvantages would be:-

   The whole process must be repeated, and a new repayment term started, with each house move. The terms of the loan may be varied at the discretion of the lender. There is no surplus cash at the end of the term. Separate life assurance is required to cover the loan. There is no investment product to produce 'excess' growth, so there is no chance of early repayment except by injection of an outside source of capital.

6. What else should we consider to help protect our investment?

   Additional products the couple might consider are:

   a combined buildings and contents insurance package; mortgage protection life insurance if the capital and interest method is chosen; possibly critical illness cover. mortgage payment protection insurance.

   These contracts have become 'standard' when putting together a suitable mortgage and protection package. Much will depend, however, on the couple's financial profile and preferences. Only a complete analysis with a financial adviser can determine their needs.

7. What are the catches associated with very low repayment rates or rates fixed for a specific term?

   Judy and Paul should be made aware of the potential problems associated with (apparently) very low fixed rates of interest. These could include:

   the rate might mask compulsory purchases of other products alongside the mortgage, such as buildings and other insurances; the initial fixed rate will be offered only if the borrowers agree to a penalty for early redemption - this may well extend beyond the fixed term; once the fixed rate period expires, there is no guarantee that the mortgage will be competitively priced, and the borrowers can still be tied in by redemption penalties; the higher lending charge, valuation and legal fees may cost more than other providers; the rate advertised may be a base rate only for low loan-to-value cases.

   Generally, few products, if any, offer 'something for nothing'. The prospective borrowers should therefore seek answers to all of the above issues.

   A lender is obliged to put products 'on the table' but not to insist upon a specific one. This should be the borrower's choice.

8. Why do we need to engage a solicitor? We could quite easily do it all ourselves. What does the solicitor do for the money?

   Most lenders insist that either a solicitor or a licensed conveyancer must be appointed when a mortgage is arranged. This is to ensure that all legal work is carried out correctly and thoroughly.

   The solicitor carries out several important roles:

   dealing with the purchase/sale transaction on behalf of the borrower; investigating title to ensure that the vendor can sell and the buyer can buy; drawing up the mortgage contract and any other documentation; dealing with financial matters, such as the deposit, the advance itself and stamp duty; ensuring that appropriate advice is given at all stages, such as putting the property on cover from exchange of contracts/conclusion of missives; dealing with any anomalies as they arise.

   If they are offered the opportunity to do their own conveyancing, they should ask themselves if they will have the time to bring all of the activity together, and if they are happy that they know enough to do it.

9. Could we get a mortgage if we decided to build a house ourselves?

10. Judy and Paul would have to provide estimates of the cost of acquiring the site (if not already owned) and all relevant building costs, including construction, connection of utilities and professional fees. Proof of planning consent must be obtained. A supervising architect is essential and the costs of engaging his services must be included in the budget.

    The lender will normally provide finance in stages, with funds drawn down at specified 'milestones' in the construction process. These are referred to as 'stage payments'. They are typically offered in either three or four portions.

    Before entering into such a arrangement, the lender will need to be persuaded that the applicant is fully committed to completing the project and has the finance to do so.

REMEMBER You should not use any information contained on this page as the basis of any action until you have discussed matters with your financial adviser.