How to buy a home with a 5% deposit

Should you buy a home with a small deposit rather than pay rent?

With low rates meaning that mortgage payments could be similar to rent, that’s a question weighed up by many potential first-time buyers struggling to save a substantial deposit for a home.

Swapping renting for buying with a 95 per cent mortgage has got easier in recent times, with banks and building societies considerably keener to lend to both first-time buyers and home movers with small deposits than they were after the financial crisis.

It always pays to have a bigger deposit, because that wins homeowners better mortgage rates and a bigger buffer against house prices falling. However, that’s not an option for everyone – so does it make sense to buy with just 5 per cent down?

How much money do you need to raise to buy a home?

Through the 1980s and 1990s, the average first-time buyer deposit was just 6 per cent, according to industry figures from UK Finance.

Today’s average first-time buyer puts down considerably more – at 16 per cent of their property’s purchase price – but those looking to buy with a smaller deposit do have decent mortgage choice.

There are now 295 mortgages on offer for those with a 5 per cent deposit, according to financial information specialist Moneyfacts, compared to 269 available a year ago.

The lowest rates on a 95 per cent loan-to-value two-year fixed rate mortgages fall between just under 3 per cent and 3.5 per cent, depending on the level of fees you pay.

To illustrate the potential costs of buying with a 5 per cent deposit, we have used the example of a £200,000 home and a £10,000 deposit – as this is close to the average first-time buyer house price and an easy round number to deal with.  

On a £200,000 home, a couple able to save £10,000 could buy their first home and face monthly mortgage payments of £820 a month – similar to what many would pay in rent for a similar property. 

As a point of contrast, to get the average 16 per cent deposit they would need to save £32,000 – a tall order even for a couple earning good money. 

Depending on where in the country you buy, the amount buyers need to raise will change, of course.

The typical first-time buyer in Britain pays £189,600, according to the ONS and Land Registry index, but while you would struggle to find a studio flat for that in London, it could buy a three-bedroom house in the North West.

What will remain the same, however, is that if you can double your deposit then you will substantially cut your borrowing costs. 

While there are decent rates and choice for 5 per cent deposits, there are better rates and a wider selection of mortgages for those with 10 per cent.

A home buyer putting down a £20,000 deposit on a £200,000 home could get monthly mortgage payments on a two-year fix down to £650.

‘Rates are still higher and the step up in cost for those with only a 5 per cent deposit does place some importance on getting a big deposit together,’ says David Hollingworth, of broker London and Country.

‘As a result any buyer should look to see how close to that next, lower loan-to-value bracket they might be. Borrowing at just over 90 per cent could cost substantially more for a relatively small amount of extra savings on the deposit.’ 

How much would a mortgage cost? 

Mortgage rates depend on two main things, how much of a deposit you put down and what kind of deal you take.

Variable rate mortgages, which are generally either at a discount to a lender’s own benchmark rate or track the Bank of England base rate, can be cheaper – but if interest rates rise then your mortgage rate probably will too. 

In fact, those mortgages linked to lenders’ standard variable rates could move at any time, as banks and building societies are free to change these at will.

A fixed rate tends to be the better option for first-time buyers, or anyone borrowing with a small deposit. Their mortgage rate and monthly payments will be set for a defined period and this provides an element of security.

The longer the fix, the higher the rate tends to be. 

This has led to the two-year fixed rate mortgage being a perennial favourite, but five-year fixed rates are also an increasingly popular and widely-recommended option.

Time passes quickly, and with a two-year fixed rate many borrowers find themselves feeling barely settled in their homes before the time to remortgage looms – along with a fresh set of fees.

How long you fix for depends on a number of things, including your attitude to risk and how likely you are to move – although bear in mind most people underestimate how long they will stay in the same property.

It’s worth talking this through in detail with a good independent mortgage broker and you should avoid simply being swayed by lower rates.

The lowest 5 per cent deposit mortgage rate is a two-year fix offered by Marsden Building Society at 2.89 per cent, but it comes with a completion fee of 0.5 per cent of the sum you borrow plus a £299 admin fee – totalling £1,249 on a £190,000 loan.

Borrowers may therefore prefer Yorkshire Building Society’s 3.19 per cent deal with fees of £495, which on a £190,000 mortgage works out to have a slightly cheaper average annual cost of £10,095 compared to £10,102.

Those fixing for five years with a 5 per cent deposit can find a clutch of cheap rates from Hinckley & Rugby, at 3.94 per cent, and Hanley BS and Newcastle BS, at 3.95 per cent. The H&R and Hanley deals are fee-free, but Newcastle’s deal has £763 fees.

For someone borrowing £190,000 on a £200,000 home with a 30-year term the difference in monthly payments is between £821 on the Yorkshire BS two-year fix and £901 on the H&R five-year fix.

Don’t just go for the lowest rate though. Andrew Montlake, of mortgage broker Coreco, says ‘The big difference in lenders is around fees, some will offer free valuations or cash backs towards legal fees, and perhaps more importantly service standards.

‘Sometimes buyers need to move quickly in a competitive market to secure the home of their dreams and getting a slightly cheaper rate is pointless if by the time the mortgage offer is received someone else has snapped up the property.’

One extra piece of good news for those buying with a small deposit is that the first-time buyer stamp duty exemption has removed another extra barrier to buying a home – saving someone £1,500 on a £200,000 home.

First-time buyers in the 1980s put down smaller deposits

Small deposit mortgages have been cast as inherently risky and a symptom of the cheap credit boom that led to the financial crisis.

However, while the Northern Rock’s 125 per cent mortgages – which wrapped up a home loan and extra borrowing on top – may have been a special kind of mortgage madness, buying with a small deposit was nothing new.

In fact, the generation of homeowners who bought their first properties in the 1980s and 1990s actually put down smaller deposits on average than those who bought through the 2000s and today’s first time buyers.

The average first-time buyer mortgage loan-to-value through the 1980s and 1990s was 94 per cent, Council of Mortgage Lenders figures show, whereas since 2000 it has been 85 per cent.

How quickly do you start paying down the mortgage?

One of the arguments for opting for a shorter-term fixed rate is that a couple of years’ mortgage payments should clear some of the debt and allow you to then remortgage to a better deal – a 10 per cent deposit loan instead perhaps.

But in the early years of a mortgage, a greater proportion of your payments go on interest than paying off capital, so how quickly would you make a dent in what you borrowed?

To find that out you need a mortgage amortisation calculator, a range of which can be found on the internet.

We used the mortgage amortisation tool at calculator.net, which showed that a borrower with a 30-year mortgage term and a £190,000 loan on Yorkshire BS’ 3.19 per cent two-year fix would clear almost £8,000 of debt in the first two years, pushing them down to a balance of £182,190.

If house prices remained steady, at the end of the two years they would be less than £200 away from shifting to a 10 per cent deposit mortgage, a level at which rates become keener.

If they opted for the five-year fix from H&R at 3.94 per cent, they would have cleared just over £18,000 at the end of that initial deal period – with a mortgage balance of £171,680 putting them within touching distance of an 85 per cent loan-to-value mortgage, a level at which rates tend to drop again.

Taking a gamble on fixing for a shorter period of time in order to get a better deal in the near future is not without risk, however.

In two years’ time interest rates are forecast to be higher than now – and while borrowers will do well if house prices rise, they may struggle to remortgage if they fall.

‘Although many buyers are considering the merit of fixing for the medium term, those in the 95 per cent loan-to-value bracket may often go down the shorter term fixed rate approach,’ says Mr Hollingworth.

‘They will be hoping that a combination of their capital repayments and any growth in house value will result in them dropping into a lower loan-to-value bracket and benefiting from a broader choice of better rates.

‘That’s not without risk, as property values may not rise and could even fall back plus interest rates could rise which could negate the benefit of dropping into a lower loan-to-value bracket as mortgage rates climb.’

Houses are almost as expensive compared to wages as they have been at any time in the past 30 years, data from Nationwide and the ONS shows

Beware house prices could fall 

Homes are more expensive compared to wages than through most of the past 30 years – and mortgage rates are near record lows.

This means that borrowers are taking on larger debts and buying properties at a higher multiple of average salaries – and that there is less headroom for house prices to rise.

House prices could fall and buyers should be aware that local market conditions and sentiment can easily mean a bigger drop in their home’s value than national house price index numbers would indicate.

‘Four or five years ago the spread between what a good agent could get for your house and one that was still training, shall we say,  was perhaps just 5 per cent above and below the asking price. Today that spread is as much as 10 per cent,’ says buying agent Henry Pryor.

‘People often say to me “in the long term house prices always go up”. It’s simply not true – 53 per cent of homes in the UK are worth less than they were before the financial crisis once you factor in inflation over that time.

‘Like other financial investments houses should come with a warning that past performance is not a guide to the future’.

If you buy with a small deposit and house prices fall, your equity can quickly be depleted, or wiped out altogether. Ultimately, this can lead to negative equity – where your mortgage debt is bigger than your home’s value.

That isn’t necessarily a problem while you live there, but it becomes one if you need to remortgage or want to move. 

For example, a borrower starts with a 95 per cent mortgage but house price falls lead to them needing to borrow 97 per cent of their home’s value, or even 100 per cent, and thus unable to get a new loan – ending up reverting to an expensive SVR instead and seeing monthly payments rise.

Meanwhile, if your equity has declined or been wiped out you may not be able to move home unless it is to a considerably cheaper property.

Both of these factors are reasons that it can make sense to take a longer rather than shorter fixed rate mortgage, for example, five years rather than two.

Those buying with a small deposit are also advised to make sure that they would be happy to live in the property for at least five years – and it will be big enough for them and meet their needs over that time.

For example, a young couple should beware buying a one-bedroom flat with a small deposit, knowing that they intend to try to have a child imminently – as they could swiftly outgrow it.

Potential buyers also need to be aware that running a home costs money. As a renter, maintenance and upkeep is the landlord’s responsibility, but as an owner if the boiler packs up or the roof needs fixing, you will need to find the money – often immediately.

Those buying with a small deposit should ensure they have an emergency fund set aside – and also that they allow enough money for buying costs and furnishing their home.