My First Property

How Does Interest On A Mortgage Work?

As with any loan product, when you take out a mortgage, you will have to pay the debt back. The amount you have to pay back will principally depend on the interest rate that comes with the particular mortgage you take out. The higher the interest rate that applies to the mortgage payments, the more you have to pay back on a monthly basis.

Now, there are many different rates charged by different lenders, and things are often further complicated by special introductory rates, and of course rates changing over the course of a mortgage under a variable rate mortgage scheme meaning you are never going to be quite sure what you are going to pay back from one month to the next. Here we will look at the overall principle of what an interest rate actually means.

Ignoring mortgages for a second, if you take out a loan for a year of £5,000 and are told you will have to pay back the loan plus 5% interest over the course of the year, then you will end up paying £5,000 (capital sum) + £250 interest = £5,250.

That should give you an idea of what the percentage in the interest rate means in tangible terms. With a mortgage product, things are more complicated in terms of the calculation, even with a fixed rate, because of something called compound interest, which is simply interest added to the initial sum over time so that the added interest itself then requires interest to be paid on it. Read our introduction to compound interest for more information on this.

The interest rate is there to ensure that the bank or building society (lender) makes money on what they lend you. If you just ended up paying back what you owed with no interest, they would make no money, which wouldn't be good for business.

The interest rate on your mortgage is predominantly influenced by the Bank of England base rate: this is reviewed regularly, and when this moves, it affects mortgage rates, as it affects the cost of borrowing for banks across their range of products, and their interbank lending with other banks and so forth.

Now, the higher the interest rate, the higher the interest rate you will pay. So if interest rates go up and you are on a variable rate mortgage, then the amount of your monthly payment will virtually always go up too.

When you are on a repayment mortgage, then each month you will pay a percentage of the capital sum (the money you borrowed for the mortgage) together with interest. On an interest only mortgage, it will just be the interest, with the lump sum of the capital to pay at the end. This is why the payments are less on an interest-only mortgage than they are on a repayment mortgage.

If you want to work out exactly what your monthly repayments will be based on the interest rate, the amount of money you borrow (capital sum) and the length (term) of your mortgage loan, then you have a couple of options.

You can either work it out yourself if you're a dab-hand at maths. To do this, you can use the monthly payment formula found on wikipedia here:
http://en.wikipedia.org/wiki/Mortgage_calculator#Monthly_payment_formula

Or, more realistically for most, you can use an online mortgage payments calculator: with these you simply plug in the various figures and the calculator tool will work out the answer for you automatically. If you find this option more appealing, then you can use our own Mortgage Payments Calculator which will do the sums for you.

The amount of money that you borrow in relation to the value of the property is called the LTV, or loan to value. So if you pay a deposit of 15% of the value of the house, then you take out a mortgage for the remaining 85%, and the LTV is 85%.

Last update: 06 May 2015

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  5. All you need to know about mortgages


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