How mortgage interest works, how it is calculated each month, the difference between fixed and variable rates, and what determines the rate you are offered.
When buying a property there is a lot to consider, and mortgages can have a steep learning curve. This is where a broker comes in: we help explain everything you need to know so you can make a confident decision. In this guide we look at what a mortgage interest rate is, how it works, and how the interest is actually calculated.
Put simply, when you take out a mortgage your lender charges interest for lending you the money. This is usually expressed as a percentage of the amount you borrow, and you pay it on top of repaying the loan itself. Different mortgage products carry different interest rates, so the rate is one of the most important things to weigh up when choosing a product, a higher rate means higher monthly payments.
Mortgage interest is generally calculated as a percentage of the amount you owe. How it plays out month to month depends on whether you have a repayment or an interest-only mortgage.
On a repayment mortgage, each monthly payment is split: part reduces the outstanding loan (the capital) and part covers the interest. Because interest is charged on the balance that remains, the interest portion shrinks over time as the balance falls, and a larger share of each payment goes towards clearing the loan.
On an interest-only mortgage, your monthly payments cover only the interest, and the full loan amount becomes due at the end of the term. Monthly payments are therefore lower, which is one reason interest-only is commonly used for buy-to-let mortgages.
Working out the interest on a mortgage can seem complicated, but the principle is straightforward. Take the annual interest rate, divide it by 12, and apply it to the balance you owe. That gives you the interest charged for that month.
As a worked example, take a £240,000 mortgage at a 4.5% interest rate:
If your monthly payment on a repayment basis were, say, £1,334, then roughly £900 covers interest and the remaining £434 reduces the loan. The next month interest is charged on the slightly lower balance of £239,566, so a fraction less goes to interest and a fraction more to capital, and so on. This is why the balance falls slowly at first and faster towards the end of the term.
Want to see this for your own numbers? Use our mortgage calculator to estimate monthly payments at different rates and terms, then speak to an adviser for a precise illustration.
A fixed rate means your interest rate will not change for an agreed period, usually two or five years. This is attractive because your monthly payments are predictable. The trade-off is that you may face an early repayment charge if you want to clear the loan early, and if rates fall during your fixed period it is difficult to benefit.
A variable rate means your interest rate, and therefore your monthly payments, can go up or down. Your lender will explain how their variable rate is set, as this varies from one product to another.
Typically you start on a fixed (or other introductory) rate, then revert to a variable rate when it ends. That reversion point is when many people consider remortgaging, both to lock in a new rate and, potentially, to reduce their monthly payments. We cover the choices in detail in our guide to what to do when your fixed-rate mortgage ends.
The rate you are offered is not arbitrary. Several factors feed into it:
Because pricing varies so much between lenders, two borrowers buying similar homes can be offered very different rates. This is where whole-of-market advice pays off, the right lender for your circumstances may not be the one offering the headline rate.
Speak to an adviser who will compare the whole market and identify the lender and product that fits your situation, not just the loudest headline rate.