How does interest on mortgages work?

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When choosing a mortgage, the interest rate you’ll be charged is one of the most important factors.

On the whole, the lowest interest rates are available to borrowers who have large deposits, or in the case of those remortgaging, significant equity in their property. Typically, you’ll need at a deposit of at least 40% to be eligible for one of the best rates. If you have only 10%, there are mortgages available but you’ll probably pay a higher rate.

This is advertised as loan-to-value (LTV).  So if you see a mortgage with a 60% LTV it means you can borrow up to 60% of the property’s value.  In other words, the minimum deposit you’ll need to put down is 40%. A mortgage with a maximum LTV of 90% is available to those with a deposit of 10% or more.

The good news is, mortgage rates have been falling and the cost of 90% deals has come down even though the rates are still higher than those on 60% products. 

Don’t only look at the interest rate, though, you need to take the fees into account too.  Our guide on fees will tell you more.

How does a mortgage work?

Your mortgage is made up of the capital – the amount you’ve borrowed – and the interest charged on the loan.  With most mortgages you pay off the capital and interest monthly over 25 or 30 years, which is why they’re called repayment mortgages.

In the early years, most of your payments go to paying off the interest with a smaller part reducing the capital.  As you get nearer to the end of the term, it switches so that you’re paying more off the capital each month.

You can opt for an interest-only mortgage where, as the name suggests, you just pay the interest every month. However, you’ll have to pay off the capital eventually so it’s important to have a repayment plan in place. The number of lenders offering interest-only mortgages has reduced over the last few years because there are concerns that many of those who have them have no repayment plan in place and could be left unable to pay back the capital at the end of the term. 
 

The interest you pay on your mortgage will depend on what type of home loan you pick

Whichever type of mortgage you have, the interest can be calculated daily, monthly, quarterly or annually. Daily interest is best as the amount of interest is calculated on the outstanding balance every day. As your balance falls, so does the amount of interest you’re paying.

With the others your balance is only reduced at the end of the month, quarter or year.  With annual interest, for example, the interest is still calculated daily but it’s based on the previous year’s balance, so it takes a year before the capital amount is reduced.

How to reduce the interest

Firstly, you need to keep an eye on the interest rates on offer. These change constantly. If you’re on a deal where your interest is fixed for a number of years, start looking around for a new mortgage about three months before it ends. It’s not usually worth switching to a cheaper rate before then as you’ll pay a penalty for leaving a deal early.

Obviously, the quicker you can pay off your mortgage the less interest you’ll pay.  Most mortgages are for 25 to 30 years.  When you switch your mortgage or move to a new home, see whether you can afford to reduce the number of years, say to 15 years.  Our calculator will tell you how much your monthly payments will be if you borrow for a shorter term.

For example, if you have a £160,000 repayment mortgage charging 5% interest, it would cost you £935.34 a month over 25 years. If you shortened it to 20 years the monthly repayments would rise to £1,055.93 but you’d save yourself £27,719 over the term.

Another way is to overpay– even £100 extra a month can make a huge difference. But make sure your lender allows you to make overpayments without charging you a penalty. Most will allow you to pay 10% extra off your mortgage fee-free each year. Also, time your payments to reach the lender just before the interest is calculated depending on whether it’s monthly, quarterly or yearly. If you’re on daily interest the timing is doesn’t matter.
 

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