Understanding interest rates
When you’ve made the decision that you’d like to buy a new home, one of the trickiest aspects of the process to understand are the interest rates and the impact they have on how much you have to pay for a mortgage.
Making the right choice on a rate when you take out a mortgage can make a big difference to how much you pay each month and how long your mortgage lasts for. Different types of mortgage affect the interest rate you’ll receive so it’s good to know the difference between the types of mortgage on offer.
Before we go any further...
All about the Bank of England Base Rate
This is the rate at which the Bank of England charges lenders, like bank and building societies, to borrow money. Some lenders refer to the Base Rate when setting interest rates for savers (who receive interest) and borrowers (who pay it).
The Base Rate is at a historically low level at the moment meaning that the mortgage deals on offer can appear more attractive. In the past when recessions occurred, rates grew to above 10% and mortgage repayments also went up causing some people to lose their homes.
Bank Of England Base Rate levels: https://www.bankofengland.co.uk/boeapps/iadb/Repo.asp
There are two types of interest rate for mortgages
With a fixed rate mortgage your interest rate and monthly mortgage repayments stay the same throughout the fixed rate period – with most mortgage providers, this is 2, 3 or 5 years.
Why they’re good
If you prefer the stability of knowing how much you will pay for your mortgage each month then a fixed rate mortgage could be the best choice.
What to watch out for
Because the rate is fixed, you would miss out on making savings if interest rates change.
Variable rate mortgages are mortgages where the interest rate is affected by a number of market conditions and can rise or fall depending on these.
Why they’re good
You would benefit from a drop in interest rates which would reduce your repayments.
What to watch out for
The opposite is also true - you could also end up paying more on your mortgage each month should interest rates rise.
What about Offset?
An offset mortgage allows you to use any savings or current account balance to reduce your mortgage balance. It works by reducing the amount you pay mortgage interest on, which is calculated by the difference between your savings (or current account balance) and your mortgage balance. For example:
Mortgage balance = £200,000
Savings balance = £25,000
Interest is charged on £175,000 only (£200,000 - £25,000)
You can usually choose to reduce the cost of your mortgage payments or to reduce the mortgage term so you pay the mortgage off sooner.
The interest rate vs. your monthly repayments
The interest rate on your mortgage deal is worked out over the total amount of your mortgage so the interest you pay on top of the cost of the mortgage will go down as you pay more and more of your mortgage off.
At the start of your mortgage, the amount you knock off the cost of the mortgage loan is very low as most of your repayment goes towards the interest. This will increase over time until you’re paying less interest and more off the total amount of the mortgage.
Interest only mortgages
These are mortgages where your repayments only go towards the interest charged on the mortgage and not towards the mortgage cost itself. This means that at the end of the mortgage term (usually 20 years +) you’ll need to pay off the total mortgage loan. Most mortgage lenders will ask you to provide details of how you plan to pay back the loan.
Most mortgage deals are offered on a repayment basis (sometime also called ‘capital & interest’), which differ from interest only in that you will be paying back both the cost of the mortgage loan (the ‘capital’) and the interest.