The government have recently announced additional support for those looking to purchase a home with a 95% mortgage. We reveal why this could be a terrible idea.
Some points to note:
Unless we state differently we are referring to repayment mortgages for this post.
How a 95% Mortgage Works
The idea of a 95% mortgage came about due to rising house prices.
In 2007 6% of all mortgages issued had a loan to value ratio of over 95%. Some mortgages even approached 100%!
Then the financial crisis happened. And shortly after there was a sustained period of bank failures, reduced credit and stricter lending conditions.
The 95% mortgage became non-existent after this, dropping to under 1% of total mortgages in 2009 and finishing at a low of 0.2% of mortgages in 2020.
To put that into perspective, that’s 2 out of every 1000 mortgage borrowers managing to obtain a 95% mortgage. And when we say 2 out of every 1000, we mean 1000 mortgages issued for the general population.
This would include existing home owners looking to remortgage in addition to first time buyers. So for first time buyers alone, getting a 95% mortgage has been very, very, very unlikely.
Why are 95% mortgages so rare?
From the perspective of a lender, if you have a 95% mortgage this only leaves 5% for a deposit. If house prices fall more than 5%, the mortgage debt you are paying will be worth more than the home (think of paying £1.50 for something worth £1). This is known as negative equity.
If you are able to continue making your monthly mortgage payments, negative equity becomes less of a problem. This is because you are still gradually paying off some of your home (assuming you are on a repayment mortgage).
But history has shown that house prices tend to fall when the economy is doing badly. Alongside this, unemployment is higher and you are statistically more likely to lose your job.
Banks also look back to the lessons that lenders learnt from 2009 – when 95% mortgages were more common. When borrowers couldn’t repay their mortgages, the bank was left with a house worth less than the money it extended out for it. This was a costly mistake that all lenders had to learn from.
Mortgage Costs at 95%
One of the biggest turn offs with 95% mortgages is the higher rate of interest charged. Lenders do this because they perceive 95% mortgage borrowers as risky business. And while this may seem unfair – there is some truth to it.
If the bank was to compare a 95% mortgage loan with a 70% mortgage loan, the majority of the manager’s time would be spent monitoring the 95% customer. Why? Because with a 70% loan to value, house prices could fall 30% and the bank could still in theory sell the home and recoup the majority of money lent (there are always other fees and costs involved so they would never get a full recovery). A 95% mortgage leaves much less ‘wiggle room’ for the bank to have if the market does start to decline.
More time monitoring a mortgage from the bank’s perspective means more time being spent by their own employees. This extra cost (both from the bank’s own employees and from having less protection with the higher mortgage) needs to be passed on – which is done in the form of a higher interest rate.
Lack of Competition
There are also fewer mortgage providers who will offer 95% mortgages compared to more mainstream lenders who lend around the 80% loan to value ratio.
With little competition in the market, first time buyers at 95% mortgages may find the following characteristics to their mortgage:
- A higher interest rate
- Higher “additional costs” levied – such as product fees and valuation fees. Note that these sometimes have to be paid at the start.
- Higher exit penalties for leaving a fixed rate agreement
- Restrictions on the portability of mortgages (i.e. preventing the mortgage from being transferred to a new property)
Fixing for Too Long
There is concern from some that more first time buyers on high loan to value mortgages are fixing into expensive mortgage deals for a significant length of time.
A large chunk of first time buyer mortgages are offered with a fixed rate of interest for a period of time. These are typically 2 years, 3 years and 5 years (but there are increasingly more mortgages coming on the market with longer fixed periods similar to mortgages in the US).
In return for getting a fixed rate of interest agreed, the home buyer usually has to pay a premium to the bank for this. It’s why you see fixed rate deals as more expensive than other mortgages that are offered solely on a variable rate. You pay for the certainty of knowing what your repayments will be for the set period.
On the flip side – a benefit of a fixed rate arrangement is that even if the Bank of England increases their rate (also known as the base rate) which causes lenders to increase the interest rates on their mortgages, you will be protected from a rate rise when in a fixed rate deal until the fixed period ends.
The reason why there is concern from some is to do with how much time is being locked up in a fixed rate. A key thing to remember is that the cost of your mortgage is influenced by the loan to value ratio (i.e. the size of the mortgage in relation to the value of the property).
If the property value increases over time and repayments continue to be made, the loan to value ratio will fall. If everything else is held equal (including the same base rate), this should lower the cost of the mortgage.
But a lower mortgage cost would only be available for the borrower after their fixed rate deal has ended. So getting into a fixed rate deal for too long can be more costly if a cheaper mortgage came along during the fixed period.
But by the same token, a future mortgage deal with a lower loan to value ratio may not turn out to be cheaper if the Bank of England has increased the base rate during this time and lenders have passed the higher rate on for their mortgages.
It can be possible to switch mortgages during a fixed term, but this often involves paying fees to the current mortgage provider for breaking the original agreement. These fees tend to be higher if you break the agreement earlier – e.g. breaking a 5 year fixed rate mortgage is likely to be more expensive to break in year 1 than in year 4.
Mary took out a mortgage on a home over 30 years. When applying Mary could afford a 10% deposit with a mortgage for 90% of the home value (or 90% LTV). She decided that she wanted to have her payments fixed each month, and decided to go for a 10 year fix period. The bank offered her a rate of 4% which she accepted.
After 6 years of repaying her mortgage, the loan to value ratio for Mary’s mortgage had fallen from 90% to 79%. She had noticed during this time that the interest rate offered by the bank on a mortgage between 70%-80% LTV was lower at 3%.
Because Mary had entered into a 10 year fixed agreement and didn’t want to pay any additional charges to the bank for breaking her agreement, she would still need to continue paying at 4% until the 10 year period was up, even though the mortgage on her home was now much lower at 79% LTV.
There are strong advocates of having long fixed rate periods. For those that feel there is a risk in house prices falling over time, it’s possible that when the fixed rate deal on a mortgage ends the cost of the mortgage could increase because the value of the property has fallen more than the amount outstanding on the mortgage, thereby increasing the loan to value percentage (although this has not been very common over the long term in the UK).
The simple fact is that no one can correctly predict the variables of the mortgage equation with any certainty, being: base rates, house price movements, fixed rate costs and job security. Even experts in the industry have fiercely opposing views on all of these topics.
The key point to take away is to ensure that your mortgage repayments are affordable for your situation. This is where the advice of a mortgage broker can be very useful.
More To Repay
Make no mistake – a low deposit mortgage does not make a home more affordable.
In fact, if a buyer used to have to save up 15% of the home value to get a mortgage at 85%, he now only needs 5% to borrow 95% of the home price. If we assume that house prices remain constant and do not experience any significant jerks up or down, this means that the home buyer now needs to be able to afford much more and will be paying off the mortgage for longer.
Affordability is vital in the mortgage business. These repayments are typically going to be paid over 20,30 and even 40 years of your life. The home buyer must be able to afford these – and it’s no fun having all of your salary spent on the mortgage each month.
Low Income Problem Remains
After you check the box on having a large enough deposit, the next challenge is being able to afford the rest of the home.
Lenders will only provide up to a fixed multiple of your salary. This is explained more in our mortgage basics guide.
With a lower deposit provided your salary now needs to stretch further to be able afford the home in the first place.
Tom saved £12,000 in a deposit for a home (it took a long time).
The homes in Tom’s local area were £240,000. This game him a deposit of 5%.
Although a 95% mortgage would be achievable for him (as he has saved the deposit of 5%) Tom’s income will need to be high enough to borrow the remaining funds (being £228,000). The bank will only lend a multiple of his annual earnings.
Assuming a lending multiple of 4 (some banks do more than this, some do less) this means Tom’s income needs to be a minimum of
£228,000 ÷ 4 = £57,000
This is an incredibly high salary for a first time buyer to be on, and illustrates the problem that the deposit is only the first hurdle for buying a home.
Why are there so many rules on mortgages?
Put simply, before the financial crisis in 2008 rules surrounding mortgages were generally relaxed. It was this relaxed nature that allowed many borrowers to take on high levels of debt, with some being unable to pay their mortgages.
A large amount of regulation was brought in during the years that followed. The new rules have meant that banks need to conduct further checks before lending to a borrower, including affordability calculations.
It may feel frustrating that a lender will not provide a higher mortgage to you – but these requirements are based on a large amount of data and statistics on what works for individuals.
As explained earlier, with a 95% mortgage there is more risk from the lender’s point of view. And with more risk, you can expect that things will be checked more, including affordability calculations.
Rising House Prices?
It’s important to note that house prices do move up and down regularly.
And it’s very rare for you to buy your home in the perfect time.
Over the long time period of your mortgage (20, 30 or 40 years) history has shown that house prices in the UK do tend to move in an upward direction. There continues to be a shortage in the supply of homes being built along with a growing population.
Rising house prices are beneficial for home owners. Even with a 95% mortgage, a rising house price means (assuming you are making the repayments) that the asset you own is becoming more valuable. This can be hugely beneficial if you decide to sell the home at a later point in time.
But it impossible to predict or know what direction house prices will go.
Home buyers need to focus on affordability first and foremost to ensure they can meet the repayments, instead of relying on market movements.
This post is for general informational purposes only. Any person considering a mortgage should obtain independent financial advice from a qualified professional.
Examples are fictional and do not reflect real world situations.
Image attribution to phatplus at flaticon.com
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