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The greater your deposit, the cheaper your mortgage will be

This leads us on to another cruelty for first-time buyers struggling with the cost of housing: all the cheapest mortgage deals with the lowest interest rates are available to the borrowers that banks want the most: those who can save the biggest deposits. All the record-breaking low-interest-rate deals plastered over billboards are generally only given to those borrowing with an LTV of 65 per cent or less, or put the other way, who can contribute a deposit of at least 35 per cent of the cost of the property they want to buy.

Most first-time buyers, especially those buying a flat in an expensive city, will be looking at borrowing with a 5 per cent deposit, or 95 per cent LTV mortgage, or 10 per cent deposit and 90 per cent LTV mortgage.

• TOP TIP

If you can push yourself to find a 10 per cent deposit, you should. There is a particularly large interest-rate jump between mortgages offered to those with a 5 per cent deposit and those available to those with 10 per cent deposit. This can work out as, for example, £1000 more a year on a mortgage of just £100,000 brokers tell me.

How your bank is judging you

The deposit is most of the battle, but once you have scraped it together you will need to persuade a bank to lend you the rest, and that is a harder and more mysterious process than it used to be. For our parents it was as simple as telling a bank how much they earned. You could borrow a multiple of this. Now, while earnings count, they are not conclusive. Outgoings count just as much. Remember that banks are worried about taking a risk on you, especially when you are a first-timer, so will make all sorts of judgements on your spending pattern to check how safe a bet they can make that you will continue to pay off your mortgage each month.

They do this through looking at your credit score (more on how this works shortly) and your spending patterns, based on analysing bank statements, any debt you are in, and any regular expensive commitments that look fixed, such as a child, dog, Camel Lights habit etc. Your prospective lender will probably want to see at least the last three months of bank statements, as well as payslips, so collect these well in advance and make sure that within this period you do not exceed your overdraft limit or have any bounced payments.

Ray Boulger, of mortgage brokers John Charcol, says you should also bear in mind that a lender will be able to see who you are paying money to, ‘so don’t spend on things you think a lender might disapprove of’ – bouts of online gambling, for example. Also he says give careful thought to signing up to Open Banking; this will allow a lender to see a longer spending history. (See budgeting chapter for more on open banking.)

You will also have to fill out an application form, detailing your outgoings. If this, or your bank statements, disclose lifestyle choices that make you look like a mega-spender, above-average numbers of holidays or meals out, say, that may reduce the amount you can borrow. The same goes if you have lots of financial debt commitments – such as car finance, personal loans or credit-card debt that you don’t repay in full each month. As long as the debt is not judged excessive, though, it is the amount you are paying in monthly payments, and so reducing what is left to spend, that influences the amount you can borrow, not the outstanding debt. Debt with less than six months to run is usually ignored.

Student loans count only in so far as repaying them means you have less disposable income left in your bank account, which feeds into how much you can afford to borrow. The fact that you have student-loan ‘debt’ does not count against you.

Banks will also look to see how your income or affordability levels may change in future. This is why a former colleague of mine went to the bank to apply for a mortgage with a very baggy top on, and took good care to pay for any Mothercare purchases with cash. If they had known she was going to have a baby, she guessed they would have judged her on balance a greater risk, likely to see both a dip in her earnings and a rise in her outgoings, even though she was pretty confident she could afford a big mortgage just fine.

SIDENOTE It is illegal for a bank to discriminate against an applicant because she is pregnant, so, like a job interviewer, you cannot be asked: ‘Are you pregnant or do you plan to get pregnant?’ But most will have questions on their application forms like: ‘Do you anticipate any changes to your financial circumstances in the next three months which might make it difficult for you to make your mortgage payments?’

You need to be honest. Lying on the application form is fraud, though you do not have to disclose your pregnancy. It should, however, make you think hard about whether you can actually afford the mortgage you want if your income or circumstances change once you have got it. A bank can only know so much about your ability to repay in the future; it is up to you to gauge how much you want to stretch yourself, knowing what life or job changes lie ahead.

Earnings matter, if only to work out whether you stand a chance of buying

Before you start browsing Zoopla it is a good idea to work out roughly how much you are realistically going to be able to borrow based on your earnings. This is only part of the picture as explained above, but a good place to begin. There are lots of mortgage calculators online that work on this basis. The rough rule of thumb at the moment, though it varies between banks, is that you can borrow about four to four and a half times your pre-tax salary. Some lenders will stretch to five times your salary, as long as it is affordable (if you are self-employed this might not apply – more below). Clydesdale bank this year launched a ‘professional mortgage’ with a maximum loan 5.5 times salaries if you are a newly qualified professional such as a doctor, vet, solicitor or architect. This is called an ‘income multiple’. That means if you earn £35,000 a year before tax you are unlikely to be able to borrow more than about £158,000 if you are buying alone. Now you can see why there’s a housing-affordability problem.

It is worth noting that the income multiple is the same for couples as for single applicants, so you are in a much stronger position if you buy with another person. Banks also treat ‘non-guaranteed’ income differently – items like commission payments and bonuses. This means you might get quirks where one bank actually offers you a bigger mortgage on a four-times-income multiple than another bank which is prepared to lend on a four-and-a-half-times-income multiple but does not allow for bonuses.

The maximum income multiple also varies with what LTV you can afford. Someone with a 25 per cent deposit is more likely to be able to borrow five times their income, whereas if you have just 5 per cent deposit, the maximum is unlikely to be more than four times. This maximum may also vary according to how much you earn, on the basis that you can allocate a higher proportion of your income to the mortgage repayments if you are richer. As Mr Boulger puts it: ‘Someone earning £80,000 won’t spend four times as much on toilet rolls as someone earning £20,000.’

How to get a mortgage if you are self-employed

You used to be able to apply for ‘self-cert’ mortgages, nicknamed ‘liar loans’, which allowed you, as a self-employed worker, to state your income without any actual proof of it. These were banned in 2014. If you are self-employed or a freelancer you apply for mortgages in the same ways as everyone else, but it is now a lot harder to get one, though do not give up before you have tried.

Ideally you need at least two years of accounts, and three years will go down even better. Many banks want these signed off by an accountant. You also need to show the income you have reported in your self-assessment tax return to HMRC; you can download the SA302 form and tax-year overview from HMRC’s website.

Some lenders – for example, Halifax (if you have a great credit score), Newcastle Building Society, Kensington and Precise Mortgages – will consider those who have been self-employed for only a year. Smaller building societies tend to be a better bet: they are less likely to pull ‘Computer says no’. You may also find it easier if you were with the same business as a full-time employee before you started going freelance.

If your earnings have been rising, banks will usually take your average income for the past two or so years. If it has fallen, they will probably use the latest and lowest figure of earnings. The best thing to do is apply to a lender you know will be most happy to offer you a deal given your specific circumstances. A broker can help matchmake. If you are self-employed, take extra care with spending in the run-up to a mortgage application. You want to act especially frugally for at least six months beforehand.

What is ‘stress testing’ and why the future matters as much as the present

Post-credit-crunch lending rules now also require banks to make sure that a mortgage is affordable not only right now but also in the future. The result is ‘stress testing’. You may be able to comfortably meet mortgage repayments on your existing salary with current low interest rates, but what if interest rates rise? You will only be able to borrow as much as you can happily afford with an interest rate of 3 per cent higher than it is today, usually compared with a bank’s standard variable rate (more on what that is in a minute) at the point at which you apply. That means most first-time buyers are stress-tested on the basis of a mortgage that might fall payable with interest of 7 to 7.5 per cent.

This protects you from overstretching yourself, but also means you are limited with how great a risk you can take on borrowing, even if you feel confident that your earnings are going to increase significantly in the future.

What is your credit score and why does it matter?

When it assesses whether or not you can afford a mortgage, a bank will score your creditworthiness based on information it can gather from your credit history or credit file as well as your bank statements. Your credit history is a record of your interactions with other financial companies: banks, energy providers and so on, kept by credit-reference agencies. Your prospective lender is looking for evidence of past borrowing behaviour to assess whether or not you will be a well-behaved borrower going forward.

You are also judged on things like how long you have been with the same employer, how long you have lived at your address, and how long you have had your bank account.

Most banks, building societies and financial companies have their own arcane bespoke credit-scoring system, based on what factors they deem important as a yardstick of reliability. No one is quite sure how they all work, how they are compiled, and how banks use them. Underwriters at banks, that is the team that assess risk, will not reveal how they compile and assess credit scores because they are ‘commercially sensitive’, so you can be rejected for having, in their view, a bad score, without knowing why, or being able to argue that their criteria are wrong.

You do not have one single credit score – this is a myth – but UK banks use three credit-reference agencies in the UK for information: Experian, Equifax and Callcredit. They compile their own credit scores based on their own assessment of your credit history, and you can check them to get some idea of whether or not you look like a worthy borrower. They are useful, but just guidelines.

Despite their opaque nature, credit scores are annoyingly important, and used for everything from overdrafts and credit cards to mobile-phone deals and, crucially, mortgages. I have received letters in my role as consumer champion at The Times from people on the verge of losing a house they want, or unable to secure an affordable mortgage, because of minor bill infractions or disputes, like forgetting to clear a small sum owed to an energy company on an account for a shared flat after everyone moves out, or missing a mobile-phone payment. These have resulted in letters from debt collectors, which damaged the reader’s credit history.

One man thought his gas account had been put on hold over a bill he did not think he owed while it was investigated; instead it had been passed to debt collectors, and a ‘late-payment’ notice added to his credit report. As a result he was turned down for a cheaper mortgage, and estimated that it would cost him over £10,000 more.

One first-time buyer couple applied for three new bank accounts – a current account each, and a joint account with the same bank that had agreed to lend them a mortgage – because they were told it would simplify things. Instead their credit score was damaged by the fact that they applied for too many financial products at once, even though the bank was getting more of their business. Totally bizarre, but really expensive, they could no longer apply for a 95 per cent LTV mortgage; they had to find another £12,000 for a deposit for a 90 per cent one. Luckily their grandparents bailed them out, but others less fortunate would have lost the house.

How to improve your credit history

If you were going to lend someone several hundred thousand pounds you would want to know a bit about how likely they were to pay you back, based on how well they had paid other people back in the past. You might be equally reluctant to lend to them if you had no evidence of their reliability because they had never borrowed from anyone before. What people do not realize is that although debt is portrayed as something you should generally avoid, having no credit history is as bad as having a faulty one. Banks need something to go on. This can be a problem for young first-time buyers whose only experience of financial products is their bank account and children’s saver they signed up to when they were twelve, or for people moving here from abroad who leave their credit histories behind in another country.

What it is useful to do, ideally at least six months before you apply for a mortgage, is create a wholesome credit portrait of yourself and, if you have no credit history, start borrowing small amounts to build one up. Start by checking your credit record through one or all of the three main credit-reference agencies mentioned above: Equifax, Experian and Callcredit. You can do this free, though be warned that you only get it free by signing up for a free trial period, after which you start to get charged automatically. Many people are caught out by this, so unsubscribe as soon as you have your score. Noddle lets you check your Callcredit score and is ‘free for life’.

I recommend that you check the credit-reference agencies at least six months before you start to apply for a mortgage, so that you have time to sort it out if it’s poor, but it’s worth doing even if you intend to apply for a mortgage next week.

• MAKE SURE YOU ARE ON THE ELECTORAL ROLL

This is essential. If you are not you won’t get a mortgage. Banks use the electoral roll to check you are who you say you are. Make sure your name is spelled right, all your address history is correct and up to date, and that you are registered to vote at the same, most recent, address.

• GET A CREDIT CARD AND USE IT IN A CHILLED-OUT MANNER

If you have a poor score because you have not had credit in the past, take out a credit card and use it for day-to-day shopping for a few months. Set up a direct debit to clear if off in full every month. Don’t just pay the minimum payment, but don’t max it out either: the perfect amount of spending is about 10 to 30 per cent of your credit-card limit. It demonstrates that you can borrow sensibly without losing the plot with all this lovely free money. A monthly credit-card balance below 30 per cent can gain you 90 points on your credit score, according to Experian, which scores from 0 to 999. A score of around 780 is fair, one of above 961 or higher is excellent. A card balance above 90 per cent will cost you 50 points.

• ADD RENT TO YOUR CREDIT HISTORY

You can now ask for rental payments to be added to your Experian credit score to demonstrate that you are a reliable rent-payer. Not all banks take this into account yet, but there are hopes that this will slowly start to change, so it is worth doing.

The Rental Exchange scheme records your rental payments and sends the results to Experian. You need to actively sign up to do this by paying your rent through a company called Credit Ladder, which then passes on your money to your landlord or letting agent, so run this past your landlord to check that they are happy with it first. Equifax and Callcredit don’t yet consider rental payments.

• DON’T APPLY FOR OTHER STUFF

Don’t be over-keen. Applying for too many accounts and loans in a short space of time does not go down well. If you can, avoid applying for anything (mobile phone, credit card, bank account) within six months or so of applying for your mortgage.

• BREAK UP WITH YOUR EX

Break any links to ex-partners and former flatmates with whom you have shared joint accounts or joint bills. If you are still wrongly linked on your report, contact all three agencies to ask them for a ‘disassociation’. Contrary to popular belief, just living with someone else who failed to pay their bills on time will not damage your credit file, but if you were financially tied to them then their poor credit history will reflect negatively on yours (conversely their excellent credit history reflects well on you). Bear this in mind before you open any kind of joint financial product.

• PAY ALL YOUR BILLS ON TIME

Make sure you do not default on any household bills. Credit reports include information from, for example, your gas, electricity, insurance and water supplier. Any defaults, even if you failed to pay just £5, stay on and damage your report for six years.

Missing your last payment on an account will cost you about 130 points according to Experian; receiving a default, when an account is passed to debt collectors, or getting a court judgement, will cost you more than 250 points. These things fade over time, though: after three years you will lose fewer points for them. If there are any mistakes on your report, or any defaults that you think are unfair or misrepresent you, then you can ask the credit-reference agency to investigate them and add a note of up to 200 words (known as a notice of correction) on your file to put them right. Lay out why you feel they are unfair, or why your circumstances have changed. For example, you might write that you missed a bill because you had lost your job, but you are now fully employed and back to paying bills on time.

• REDUCE YOUR DEBTS (BUT DON’T WORRY ABOUT STUDENT LOANS)

Pay down any debt you have as much as possible before applying for a mortgage: lenders will look at your ‘balance trend’ as part of credit scoring. This does not include student loans. Arguably you would be better off boosting your deposit than using savings to pay down any student loan. See the next chapter for more on why.