Most mortgages these days are standard capital and interest repayment mortgages, also known as ‘repayment mortgages’. This means that each month you repay all of the interest charged on your borrowing for the month, plus a small amount of the capital that you originally borrowed.
Over the term of your loan, you will eventually repay all of the capital you borrowed via your monthly repayments so that your loan is fully paid off. The interest that you pay each month is effectively the fee you pay to your lender in return for borrowing the capital from them. It is how lenders make their profit.
How much interest you end up paying during the lifetime of your mortgage will depend on a number of different factors. These include:
- The interest rate you are charged by your lender
- The amount you have borrowed
- How long it’ll take you to repay your mortgage
- The type of mortgage deal you have been offered and whether the interest rate is fixed or variable
In this article, we’re going to explore how mortgage interest rates work and how you can work out how much interest you are paying on your mortgage.
How do mortgage interest rates work?
Mortgage interest rates determine how much you’ll be charged for the money you borrow to buy a property. It also determines what your monthly repayments will be on that borrowing. The higher your interest rate, the higher your monthly repayments will be. It makes sense therefore to try and obtain the lowest possible interest rate so that you will pay less to your lender in borrowing costs.
Financial institutions all set their own interest rates, although they are generally all linked to the prevailing Bank of England ‘base rate’. Base rate is the single most important interest rate in the UK. The base rate determines the rate of interest paid to Commercial Banks for the money that they hold with the Bank of England. This in turn determines how much the Commercial Banks pay to their customers who deposit money with them and how much they charge to customers that borrow from them.
By increasing the base rate, the Bank of England makes money more expensive to borrow. Lenders then increase both their borrowing and deposit interest rates in line with this increase. If the Bank of England reduces its base rate, the money is considered cheaper and lenders will generally reduce their interest rates by a similar amount. This is one of the main mechanisms used to help control inflation in the UK economy.
Each mortgage lender will set its own base rate or ‘Standard Variable Rate’ (SVR) for mortgage borrowers. This rate will be linked to the Bank of England’s base rate and this will generally move up or down in line with the changes in base rate. A changing interest rate can make budgeting unpredictable for borrowing customers, particularly those on variable-rate mortgage deals.
To help remove some of this uncertainty, many lenders started offering fixed interest rate deals where they are guaranteed to keep the interest at a fixed rate during an agreed initial term, regardless of what they, or the Bank of England, did with underlying interest rates.
This makes budgeting unpredictable for those on variable-rate mortgages. To help remove this uncertainty, many lenders started offering fixed interest rate deals, where they guaranteed to keep the interest at a fixed rate during an agreed term, regardless of what they, or the Bank of England, did with interest rates.
Find out more – ‘What is a fixed-rate mortgage?’
How much of my monthly repayment is interest?
When you first start repaying your mortgage, your borrowing will be at its highest level. The monthly cost of this borrowing (the interest charge) will also be at its highest level. Each month, your mortgage repayments will need to fully cover the interest charge applied, as well as pay a little extra to reduce your mortgage borrowing.
As the years go by, the little extra you have been paying to reduce your borrowing will start to have an effect. Your mortgage balance will start to reduce. This will then reduce the amount of interest charge you incur because you have less borrowing.
Since your monthly repayments stay the same each month and the amount of interest charge starts to go down, a larger proportion of your monthly repayment will go towards repaying your loan. This means that your mortgage borrowing will only reduce quite slowly to begin with. This is because you are mostly paying interest each month initially. It reduces quite quickly later on as more of your monthly payment is used to pay off your borrowing.
You may hear this process of paying your loan down referred to as ‘amortization.’ Your lender or mortgage advisor will be able to provide you with an amortization schedule for your mortgage. This shows the breakdown of how much interest and how much capital you will be paying in each monthly payment throughout the term of your loan. It is interesting to see that you only really start to pay down your mortgage when you are around halfway through the loan term!
How does an interest-only mortgage work?
You may have heard of ‘interest-only mortgages’. As the name suggests, with this type of mortgage you only pay the interest charges on your loan each month and not actually any of the loan itself. This results in lower monthly repayments. However, at the end of the mortgage term you’ll still owe the original amount that you borrowed.
These types of mortgage were popular prior to the 2008 financial crisis. They allowed people to borrow cheaply on an interest-only basis without necessarily having a guarantee of how the debt would eventually be repaid. They were often linked to some separate form of investment, such as a pension plan, unit trusts or endowment policy, which were expected to produce a capital sum on maturity. This could then be used to repay the outstanding mortgage borrowing.
The collapse of the financial markets in 2008 threw many of these arrangements into question. It resulted in thousands of interest-only customers facing uncertainty about whether they would be able to pay off their mortgage at the end of the agreed term.
For this reason, interest-only mortgages are now very difficult to come by. They are only really suitable for those that have a large amount of equity in their property and have a clear and reliable repayment plan in place. This will repay the capital lump sum back at the end of the term. One exception to this, however, is buy-to-let mortgages. These are seen as a more commercial product. Some lenders may accept that landlords will have alternative structures to their borrowing and repayment plans.
Find out more – ‘Different types of mortgages’
Do you need help understanding the interest that you pay or will be paying on a mortgage? We’re here to help you! Get in touch with Mortgage Light and we can talk you through how much interest you might be paying on your mortgage and alternative deals that might help you to reduce this expense.