Understanding mortgage interest and how it’s calculated
Mortgage interest rates help determine how much you’ll pay back in total when you take out a mortgage. Our guide explains how they work.
Key takeaways
Mortgage interest is the cost of borrowing money to purchase a home, calculated as a percentage of the loan amount
Opting for a 20 or 25-year mortgage reduces the total interest paid but increases monthly payments
Paying more than the monthly instalment reduces the capital faster, lowering overall interest but be aware of potential early repayment charges
Mortgage deals can be withdrawn at any time by providers, if this happens you’ll need to reapply, which may result in a different interest rate
What is mortgage interest?
Mortgage interest tells you how expensive it will be to borrow money for the purchase of your home. For every pound you borrow, you’ll have to pay it back with interest at an agreed rate.
Mortgage interest rates can be both fixed for a set period or variable. This will depend on the terms of the lender. Read our guide to find out more about the types of mortgage available.
How does mortgage interest work?
Mortgage interest is calculated as a percentage of what you borrow. It’s repaid over the length of your mortgage deal, known as the term. As a simple example, if you borrowed £100,000 at an interest rate of 2%, you’ll have to pay £2,000 per year in interest.
However, most mortgages are repayment mortgages. This means that, as well as paying off the interest every month, you also pay back a chunk of capital (the original amount you borrowed). This way, by the end of the term, you’ll own the property outright.
It’s worth noting that the longer the mortgage term, the lower your monthly payments will be but you will pay more in interest overall.
For example, if you borrow £200,000, you’ll pay back less in interest over a 20-year mortgage than a 30-year mortgage. Mortgages can also be interest-only, where you’ll only cover the interest charged on loan.
So, if you borrowed £200,000, you’ll still owe that amount at the end of the deal, and you’ll need to have some way of paying off the debt.
How do lenders set mortgage interest rates?
The interest rate you’ll pay on a mortgage is based on a range of factors. These include the Bank of England's Bank Rate and the policy of your chosen lender. Banks and building societies know they need to offer a competitive rate to attract borrowers, while also making enough in interest payments to cover risk and make a profit.
The factors which play a part in the rate of interest you end up paying also include:
Mortgage interest factors
The cost of the money
Where the lender gets their money from, which they will then lend to you, influences the interest rate. It might be from savings deposits from its existing customers or borrowing from the market as a whole.
The Bank of England Base Rate also has an impact on the cost of funding for the lender. The base rate is the rate at which banks lend to each other.
Your credit history
Your will have a strong bearing on the interest rate you’ll be offered. For example, if you’ve had debt problems in the past and missed debt repayments, you could have a low credit score.
Lenders will be wary, which is why you're likely to be offered higher mortgage rates than other borrowers with a stronger credit record.
Check your credit score for free and pick up tips on how to improve it with MoneySuperMarket’s Credit Score service.
The risk to the lender
When deciding what interest rate to charge you, the lender needs to ask what the chances are of you defaulting on the mortgage. If so, how will they recoup their losses? This is where the loan-to-value ratio (LTV) is important. The higher the proportion of the property’s value you wish to borrow, the more risk for the lender.
For example, if you borrowed £90,000 on a mortgage to buy a £100,000 home, your LTV would be 90%. Should you default, the bank could repossess your home. However, the property is only worth £10,000 more than the bank lent to you.
In contrast, if you only need to borrow £60,000 for the same home, your LTV would be 60%. This is because you would own more equity in the property. If you then fell into difficulties and couldn’t keep up with repayments, the bank could take ownership of the property, and there is more equity there for it to recoup its money.
For this reason, the lower your loan-to-value ratio, the lower the interest rates you’ll be offered by lenders.
Loan-to-value ratio examples for a home worth £250,000:
Homeowner equity/deposit | Mortgage size | LTV ratio |
|---|---|---|
£25,000 | £225,000 | 90% |
£62,500 | £187,500 | 75% |
£100,000 | £150,000 | 60% |
Lender’s targets and competition
Competition in the mortgage market will affect the interest rates on offer. If lenders are keen to attract new business, they might ‘under-cut’ and offer super-low rates to get new customers onto their books. This would act as a way of competing with other banks and building societies.
Conversely, when they want to control their mortgage books, they might increase rates to reduce the amount of new business coming in.
How often do mortgage interest rates change?
Mortgage interest rates tend to change regularly – even on a daily basis. While these variations will not affect fixed-rate mortgages, they will have an impact on adjustable-rate mortgages and reset rates in the loan agreement.
When you’re applying for a mortgage loan, it may be worth asking your lender to lock in the rate if possible. This way, should rates oscillate before you secure your deal, you’ll be protected against higher interest rates.
How does mortgage interest work with different mortgage types?
When it comes to taking out a mortgage, your choice is not limited to repayment or interest-only. You can also decide the type of mortgage you wish to go for, which will affect the amount of mortgage interest you’ll pay. The three most common types of mortgage are:
How do mortgage rates work with different types of mortgages?
Fixed-rate mortgage
The interest rate you pay remains the same for the introductory period of the mortgage, commonly two or five years. This means you’ll know exactly what your monthly repayments are each month, making it easier to budget.
Variable-rate mortgage
The interest rate you pay is determined by your lender and can change from month to month.
This means that your monthly repayment amount can go up and down. It can also be influenced by the Bank of England’s base rate, but it is at the lender’s discretion. Most initial deals will be at a discounted rate from the lender’s standard variable rate (SVR).
Tracker-rate mortgage
Tracker rate mortgages work in a similar way to a variable-rate mortgage, with the key difference being that the tracker rate mortgage is generally linked to the Bank of England's base rate.
As this rises or falls, so do the interest rate of the tracker and your mortgage repayments.
For more information, see our guide on how to choose the right type of mortgage.
How long does it take to pay off interest on a 30-year mortgage?
You pay interest on all mortgages up until the end of the agreed term. So, by definition, it takes 30 years to pay off the interest on a 30-year-mortgage.
You can reduce the time it takes to pay off the interest on a mortgage (and the overall amount of interest you’ll pay) by:
Choosing a shorter term: Opting for a 20-year or 25-year mortgage will mean you pay fewer monthly instalments and less interest overall. However, with a shorter loan term you’ll have higher monthly payments
Overpaying: Most mortgages allow you to pay more than the agreed instalment every month. This helps you reduce the capital you owe more quickly and means you’ll pay less in interest overall. However, there is usually a limit to how much you can overpay before you face an early repayment charge. So, make sure you check this beforehand
What is an interest-only mortgage?
As the name suggests, with an interest-only mortgage, you only pay the interest every month. However, you’ll have to pay off the capital at the end of the mortgage term. So, it’s a good idea to have a repayment plan in place.
The number of lenders offering interest-only mortgages has reduced over the last few years. This is because there are concerns that many of those who have them have no repayment plan in place, meaning they could be left unable to pay back the capital at the end of the term.
Compare mortgages with MoneySuperMarket
It’s easy to find and compare mortgages from a range of lenders with MoneySuperMarket.
Whether you’re looking for a fixed-rate or variable-rate mortgage, our mortgage comparison tool can help you find a great deal for your individual circumstances.
When comparing deals, it’s not just the headline interest rate to consider. You should also factor in any fees, such as an arrangement fee to set up the mortgage, and potential early repayment charges. This would be the case if you’re able to pay off the mortgage early or wish to switch to a better deal.
Your home may be repossessed if you do not keep up repayments on your mortgage.
Author
Saarrah Mussa
Former Content Writer
Saarrah was a MoneySuperMarket's in-house pet insurance expert. With broad experience writing across insurance products Saarrah is acutely aware of the complexities and costs consumers have to face...
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Rebecca Goodman
Personal Finance & Insurance Expert
Rebecca is an award-winning financial journalist with over a decade of experience writing for print and online media. Her mission is to take the jargon out of personal finance and to help everyone...
