Understanding interest rates can help us understand how to pick the right mortgage product. Read on to gain some insights into why we pay interest, when we pay it, and what it means for your personal finances.
What is interest?
We can think of interest as the cost of borrowing money from someone else. The word interest comes from the Latin word interesse, meaning compensation for loss.
Typically a loan is a service provided by a bank or financial institution, and the interest is the cost of that service. Interest is typically charged as a % of the loan value, and paid each month or per year.
For a repayment mortgage in the UK, the interest on the loan is usually calculated daily and paid at the end of each month.
This means that if an extra repayment is made in the middle of the month, the interest rate is adjusted accordingly.
If Ron takes an interest-only loan for £60,000 at a rate of 5%, his yearly interest charge is £60,000 x 5% = £3000. So his monthly interest payment would be £250 (£3000/12 = £250). With an interest-only loan, the original loan amount of £60,000 will remain the same until he decides to pay it off.
If you decide to take out a loan without paying monthly interest, you’ll suffer the exponential effects of compound interest.
In effect, the longer you have the loan, the more the interest compounds. This is because you owe more interest on the unpaid interest payments. As a result, your overall debt will soar. Nearly all mortgage products require you to pay monthly interest, therefore mortgage borrowers do not suffer the impact of compound interest.
When do I pay interest?
Nearly all mortgage loans require borrowers to pay off interest each month. A mortgage broker’s job is to ensure that the monthly interest payments, and any capital repayments, are affordable for the borrower. The broker does a fact find, taking into account the customer’s income and individual circumstances to assess this.
Is there any choice when it comes to interest rates?
The market for mortgages is huge - many lenders are competing for your business (there are over 200 providers in the UK)!
As a result, there are many different interest rates on offer.
In addition to seeking advice from your mortgage broker, you can make some comparisons and calculations on how much a loan would cost you per month.
Here are the things to consider when comparing the total cost of the interest you pay on a fixed balance loan over its lifetime:
- Size of the loan you are taking. Remember that interest is a % of the loan amount.
- £60,000 at 5% would cost £3000 per year (£250 per month)
- £600,000 at 5% would cost £30,000 per year (£2500 per month)
- Length of the loan. Remember that you are charged interest for every day that you are borrowing.
- over 5 years: £60,000 at 5% would cost £15,000
- over 30 years: £60,000 at 5% would cost £90,000 (assuming interest-only repayments)
- Interest rate
- 10% interest rate on £60,000 would cost £6000 per year
- 5% interest rate on £60,000 would cost £3000 per year
- Remember that interest rates are usually only fixed during an introductory period
What is the difference between fixed and variable interest rates?
Due to the competitive mortgage market, lenders tend to offer a “fixed rate” during the initial mortgage period. This typically lasts 2-5 years, and gives the customer the benefit of knowing their monthly payment amount, and locking in an interest rate that won’t change.
Following the fixed rate period, the interest rate will revert to a variable rate.
A variable rate of interest means that the interest rate could change from day to day, or month to month. It will usually be linked to an index. In the UK, most variable rates are linked to the Bank of England. The Bank of England can change its rate, depending on current economic circumstances.
What about a repayment vs. interest-only loan?
Your monthly interest on a repayment loan would reduce month by month, because you are slowly reducing the size of the loan.
Most mainstream mortgage products are repayment loans.
Your monthly payments combine interest and repayment. As you reduce the amount of loan capital, the ratio of loan capital vs. interest in these monthly payments changes over time.
When you start off, the loan amount is large, so most of the payment will go towards the interest. As the loan amount reduces, the interest becomes lower, and more of your payment goes towards the loan capital.
With an interest-only loan, you choose when to make the repayments. Until you do so, your monthly interest payments aren’t going to change.
It is rare to find a stand-alone mortgage product that allows interest-only repayments. Equity loans, such as Help to Buy and the Proportunity Loan, are designed to work in combination with a mortgage repayment loan. These equity loans are typically for a lower loan amount.
Should I look at anything further than the interest rate of the loan? Where do I even find that information?
Lenders are required to show their APR. This allows you to compare products - including interest and additional fees between lenders. The APR stands for annual percentage rate. This combines:
- Interest (cost of borrowing)
- Compulsory fees (including arrangement fee, and any other fees)
Perhaps the interest rate is 14%, but the APR could be 16%. The impact of the arrangement fee is shown as the equivalent of a 2% of interest. The objective is to show the amount you will pay each year over the full term of the debt.
However - many borrowers later move their mortgage to another lender. So looking at the APR is not a true indication of the amount they will pay over the lifetime of the loan with that lender.
Another term often used is “representative APR”. Lenders can use this term as long as 51% of their successful applicants qualify for the APR advertised. The remaining 49% are likely to get a higher rate.
AER is a similar term, but used for savings accounts. Read more about AER here.
How do I know that I’m making the right choice and finding the best interest rates?
It's all quite confusing! A qualified mortgage broker will be able to explain to you the interest rate, APR and monthly payments. In fact, mortgage loans are only available through regulated advice (either an intermediary mortgage broker or in some limited cases qualified in-branch advisers). This means that lenders tend not to publish interest rates online, but rather to make them available only to these intermediaries. This protects you as a buyer - a mortgage broker is trained to filter through the complex information and ensure that they only recommend the product that makes sense for you. By signing up for an account with Proportunity, you can choose to be connected with a qualified mortgage broker.
See this fact sheet from the Money Advice Service for further information on interest rates.