A 100% mortgage allows borrowers with little or no cash the opportunity to take out a loan that covers the entire cost of buying a house. They are also called zero-deposit mortgages.
Too good to be true
The advantage of this kind of loan is that it gives some people a way out of renting and on the housing ladder – still a lifetime aspiration for many. A typical mortgage requires buyers to have saved at least 5-20% of the property’s price, with the lender extending credit on the remainder.
With a large deposit, the amount borrowed overall will be smaller, you typically get access to lower rates of interest and the chances of mortgage approval are much higher.But 100% mortgages are high loan-to-value mortgages, which are considered much more risky and usually cost the borrower a lot more.
Most mortgages of this type are guarantor mortgages, where a family member must commit to making the mortgage payments if you are unable to do so. The homebuyer’s parents or grandparents may have to put some money into a savings account linked to the mortgage. With rising house prices, borrowers have been increasingly relying on the 'bank of Mum and Dad' as family members often want to help each other financially across generations.
But sometimes, this lending is informal and according to recent research accounts for about £5bn in the UK, making families the tenth largest lender in the country.
What’s the catch?
There are two drawbacks to this kind of mortgage. Higher interest rates and negative equity- the risk of being trapped with a mortgage debt bigger than the value of your house.
House prices can fall as well as rise. If house prices continue to rise, borrowing the entire value of your home may not be such a big problem.
But if the value of your property falls by as little as one percent, you could end up owing more money than what your property is worth and what you can easily repay. Finding a new mortgage can be harder too because you become trapped with your existing lender and end up having to pay whatever rate is applicable. And because these kinds of mortgages are much riskier for you and the lending bank than mortgages where you provide a deposit, the interest rates tend to be much higher and there are fewer mortgage choices available.
The trap most people fail to account for when thinking of buying a home is the powerful effect of compounding. When you’re highly leveraged- borrow a lot more than what you an easily repay - even a slight rise in interest rates can be crippling.
Also, present bias, the tendency to over-value immediate rewards at the expense of long term implications, can push us to buy sooner than later - even if it means borrowing beyond our means. Another problem for homeowners with zero equity and little cash reserves is that any personal hardship such as losing your job or having a medical emergency can force you to default. You may end up unable to sell up and move – for example to take up a promising new opportunity in a different town.
Level playing field
Although 100% mortgages may appear to level the playing field between buy-to-let investors and first-time buyers trying to jump on the housing bandwagon, in reality they further increase demand – pushing prices even further out of reach.