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How does mortgage interest work?

Understanding mortgage interest and how it’s calculated

published: 17 November 2022
Read time: 5 minutes

Mortgage rates help determine how much you’ll pay back in total when you take out a mortgage. Our guide explains how they work.

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 interest on mortgages work

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 more you’ll pay 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 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:

  • 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 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 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 Bank Rate and the policy of your chosen lender. Banks and building societies know they need to offer a competitive rate to attract borrowers but must make enough in interest payments to cover risk and make a profit. The factors which play a part include:

The cost of the money

Where the lender gets their money from, which they will, in turn, 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 credit score 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 and advice on how to improve it with MoneySuperMarket’s Credit Monitor 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 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.

Do you pay off interest first on a mortgage?

On a standard repayment mortgage, your monthly repayment is made up of a combination of part of the capital (the loan amount you’ve borrowed) and the interest charged on loan. With most mortgages, you pay off the capital and interest monthly over 25 or 30 years.

In the early years of your loan, most of your monthly repayment goes towards servicing the interest on your debt, with a smaller part chipping away at the capital. But as you get nearer to the end of your mortgage term and your loan is smaller, then the interest payment reduces, and you’ll start to pay off more of the capital each month.

With most mortgages, you’ll be able to overpay each month (up to a set amount, for example, 10%). This can help reduce the capital more quickly, meaning you pay less interest overall. Overpayments go straight towards paying off capital.

Our mortgage repayment calculator can work out what your repayments will be. These will depend on how much you’re borrowing, the interest rate and fees of the deal, and the term of the mortgage.

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.

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

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.

Can my mortgage deal be withdrawn?

Unfortunately, the answer is yes, and this could happen at any time. Mortgage providers often reserve the right to withdraw a mortgage offer at their own discretion. If this occurs, you’ll need to start the application process all over again, including eligibility and affordability checks. After this, lenders will draw up a new mortgage offer, which may end up being at a different interest rate.

As the UK experiences a period of economic uncertainty, some mortgage providers have pulled deals from the market and withdrawn offers. But don’t worry, as there are still plenty of options to choose from. With MoneySuperMarket, you can scour the market and find the mortgage deal that best suits your needs and pockets.

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 is at risk if you do not keep up repayments on a mortgage or other loan secured on it.

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