Mortgages- Do Your Homework!

One of the largest decisions many of us may face is whether to buy or rent a property. In some circumstances renting can be more convenient than purchasing  property, particularly if you want something temporary or if you don’t wish to be tied down to a location. However, in the long term it might not be the best move to make financially, since renting  effectively means you are paying someone else’s mortgage. They will most likely price the rent at more than their monthly mortgage payments in order to make a profit.

Renting can also be seen as “dead money” as you have nothing to show for it at the end. I rented on and off for 7 years spending tens of thousands of pounds with no property in my name at the end of it. On the other hand, purchasing property with a mortgage means that although you are still making monthly payments, these may be even lower than the average rent prices and you will own a property once the mortgage is paid off. Furthermore, it can also be seen as an investment since the value of the property is likely to increase considerably with time.

One of the main hurdles faced when purchasing property is raising enough money for a deposit. Despite some offers handed to first time buyers ^[1] allowing them to only put down a 5% deposit ^[2]; given property prices in some areas such as London, even raising 5% of the house value can prove to be difficult. There is no doubt that saving enough money for a deposit requires disciplined saving as well as potentially asking for help from family.

But what about interest rates?

In Islam caution is required when it comes to interest. However, Ayatullah Sistani permits taking out a mortgage provided the intention is not to take a loan and pay interest despite you knowing you will have to pay this, (see last question on this reference ^[3]). Rather, your intention should be mainly to provide a home for yourself and your family and making a long-term financially sound decision.

Initially when planning to take out a mortgage the main things to consider are:

• Amount to be borrowed – How much are you going to borrow from the bank? The more you put down as a deposit the less you need to borrow. For example if a house costs £250,000 and you put down a 5% deposit, that means you’ve put down £12,500 and you will need to borrow £237,500. Your Loan to Value (LTV) (this is the loan amount divided by value of the house, multiplied by 100 to convert to a percentage) is then 95%. However, if you put down 10% i.e. £25,000 your LTV is only 90% and you only need to borrow £225,000. The lower your LTV is, the better your mortgage deal will be as the amount of interest you pay is partly based on your LTV.

•  Terms of loan – How long are you going to spend paying the loan back? Most people opt for a 25 year or 30 year mortgage term. The advantage of a long- term mortgage is that your monthly payments will be lower however overall you will pay a lot more interest in comparison to paying your loan back in a shorter amount of time.
• Interest rates – The higher your interest rate the more interest you pay back. Your interest rate depends partly on your LTV and partly on what type of mortgage deal you go for ^[4].

The main types of mortgage are:

• Fixed Rate – Your interest rate stays fixed for a period of time, e.g. 2 years or 5 years. This means that if the Bank of England increases their interest rates your interest rate stays the same for your fixed rate period, i.e. your interest rate is not affected by the increase. The longer you fix for the higher the interest rate you pay as you’re passing more of the risk to the bank.
• Tracker – This tracks the Bank of England base rate so as long as this rate stays the same (currently very low at 0.5%) then your mortgage rate stays the same but when the Bank of England increases the interest rate then your monthly payments also increase. Tracker mortgages are usually quoted, for Bank of England base rate +1.5% (BBR +1.5%) so currently your interest rate would be 0.5% + 1.5% = 2% but if the Bank of England increase the base rate to 0.75% then your interest rate goes up to 2.25%.
• Variable Rate – On this rate your bank can change the rate whenever they wish, whether or not the Bank of England changes their rate, thus it is generally seen as the riskier option.
• Fixed Rate Offset – It may also be worth considering a Fixed rate offset mortgage. This is where the bank calculates the interest on your mortgage on the net of the loan and savings in your bank account without you needing to actually use your savings to pay the mortgage^[11].

Important note about interest rates

When you take out a mortgage, although the interest rate may seem low, in reality you will pay back a lot more than you may initially think. For example, say you borrow £200,000 over a period of 25 years and your interest rate is 5%. You may do a normal percentage calculation (£200,000 * 5% = £10,000) and assume this is the amount of interest you’ll pay back. However, if you input these details into a repayment calculator ⁵ you will see the interest you’ll pay back is over £150,000! Consequently, in total you will pay back £350,000 altogether: £200,000 loan + £150,000 interest i.e. 75% interest.

But why is the interest paid much higher than you initially thought? Well, it’s because banks using a different formula for working out interest repayments, which can include multiplying by the power of the number of years of the mortgage. Before signing up to a mortgage deal make sure you get a Key Facts Illustration ^[6] (KFI) document which should state for example “For every £1 you borrow you will pay back £1.75”. It will give you a much clearer idea of what you should expect to pay.

If you choose an interest only mortgage it means you only ever pay the interest each month and are expected to pay back the full amount borrowed at the end of the term. However, a repayment mortgage is the most common type. It is less risky and is where your monthly payment pays off both the interest and capital. ^[7]

Even with a repayment mortgage, in the early years most of each month’s payment is just paying the interest for that month, as the interest is so high. Over time a greater percentage of the monthly payment goes towards paying off the capital.

So, how can you save money and pay off your mortgage earlier?

• Borrow less – The less you borrow the less interest you pay and the quicker you can pay back your loan. In Islam we are encouraged to be moderate and not overstretch ourselves, so if you are only a couple there is no need to stretch yourself so much and try to buy a 4 bedroom house near Central London if it is going to be too much of a financial burden.
• Borrow over a shorter term – If you can, try to choose a 25-year payment term instead of a 30-year one, or a 20 year one instead of a 25 year one, as the shorter the term the less interest is paid overall.
• Get the lowest interest rate possible – This is partly determined by your LTV but you also need to shop around. You should also check your credit report, if your address history is incomplete or you aren’t registered on the electoral register or even registered at two different councils; your credit rating can be adversely affected. This means your preferred mortgage deal could be rejected and you may need to end up taking a more expensive one. Check your credit report before applying for a mortgage; you can get a free report from Experian ^[8] using their 30-day free trial before the end of which you have to cancel it to avoid the monthly fee. So the amount, term and interest rates discussed earlier all need to ideally be low.

• Make overpayments – Say your bank asks you to pay £1000 per month, in the early years most of this will go towards interest and a small amount towards the capital (the amount actually borrowed) however, every pound you pay on top of the normal monthly payment will go towards the capital. This is due to the fact that the interest for that month has already been paid thus you will not be paying interest on that amount again over the whole term of the mortgage. So if you pay £1200 instead of £1000 you take an extra £200 of the capital and save a significant amount of interest.

In fact using an overpayments calculator, ^[9] if you have a £200,000 loan at 5% interest over 25 years your monthly payments are around £1,168. However, if you increase your payments to £1,368 you save £41,749 of interest and pay off your mortgage over 6 years earlier! This £41,749 would be a complete saving, as the capital would have had to be paid anyway. A significant number of homeowners have overpaid in recent years ^[10].

However, before taking out a mortgage check if your bank allows you to make overpayments, as some do but have limits. For example, First Direct allows you to pay 10% of your outstanding loan balance back in overpayments each year, which is easy to stay within during the early years but not towards the end of the term.

Before taking out a mortgage deal always ask if they calculate the interest daily, monthly or yearly. Ideally you want your bank to calculate the interest on your mortgage daily or monthly. This is so that when you overpay in your monthly payment or even just pay the normal amount the interest for the next month is a bit lower as it takes this reduction of loan outstanding into account. If your bank only calculates interest yearly then you only see the benefit of the overpayments after a year.

• Shop around – Even if you recently bought your house and have barely dented your loan, you could still get a better deal due to your LTV decreasing. For example, say when you bought your house it was worth £250,000 and you put down a 10% deposit of for example £25,000 so you borrowed £225,000. Your Loan to Value would then have been 90% (loan of £225,000 divided by £250,000 value, * 100 = 90%).

Now let’s say that after 2 years you only pay off £10,000 of capital because most of your monthly payments are covering interest. If your house value increases to £300,000 your LTV will significantly decrease. That’s because your LTV is now an outstanding loan of £215,000 divided by the value of the property of £300,000 which would give you an LTV of 71.7% compared to the previous LTV of 90%.  It’s significantly lower mainly due to the increase in value. The lower your LTV the lower your interest rate, deals are normally quoted at 95% LTV, 90% LTV, 85% LTV (i.e. in bands of 5%) so you could get a 75% LTV deal or overpay and/or wait for the value to increase to bring your LTV down to 70% and get a better deal.

Note– If you are on a fixed term deal such as 2 year fixed or tracker you are likely to have to pay a penalty fee for coming out of the deal early. Your best option here would be to work out if it’s worth it or not. If you are near the end of the deal it is always worth shopping around to see if you can benefit from your lower LTV.

• Do your research – Ensure you do some thorough research before deciding on whether to buy or rent and which mortgage to take out etc.

Overall although mortgages can be very expensive, you can still save a lot of money by following the tips above.  If you are sensible in terms of the amount you borrow, shop around for the best deals, as well as try to regularly overpay by fixing your standing order higher than the amount the bank asks for, you can save a lot of money and pay years earlier. Also by the time the loan is paid off, you will hopefully own a property that has risen significantly in value. In an area where house prices are rising quickly you may find your yearly mortgage payments are much lower than the rise in your home value so you could actually be making money on the property from your first year. Sound financial decisions are important in Islam. We work hard to earn halal money so should be careful to spend it in the right way and save where possible.

Written by Saqib Hussain

^[1] http://www.moneysupermarket.com/mortgages/first-time-buyers/

^[2] http://www.knowyourmoney.co.uk/5-percent-deposit-mortgage/?gclid=CjwKEAiA1JuyBRCogJLz4J71kj0SJADsd6QRm7prqq0K4Bs6OVyhQvSI7csXTHLUJEOVIrSWT-DvlBoC217w_wcB

^[3] http://www.sistani.org/english/qa/01256/

^[4] http://www.thisismoney.co.uk/money/mortgageshome/article-1583960/Fixed-rate-vs-tracker-variable-SVR-mortgages.html

^[5] http://www.hsbc.co.uk/1/2/mortgages/repayment-calculator

^[6] https://www.moneyadviceservice.org.uk/en/articles/keyfacts-documents-explaining-your-mortgage

^[7] http://moneyfacts.co.uk/guides/mortgages/repayment-and-interest-only-explained/

^[8] http://www.experian.co.uk/

^[9] http://www.hsbc.co.uk/1/2/mortgages/overpayment-calculator

^[10] http://www.theguardian.com/money/2011/apr/09/take-years-off-your-mortgage-overpaying

^[11] http://www.moneysupermarket.com/mortgages/what-is-an-offset-mortgage/