Wednesday 31 January 2018

How interest rates work

Author: Editorial Team

When you take out a mortgage, you’ll repay the loan to your provider with interest. Interest is calculated by a percentage of the amount you borrow and is added to your mortgage. As Investopedia says: “Simply put, every month you pay back a portion of the principal (the amount you’ve borrowed) plus the interest accrued for the month.”

This means you’ll end up repaying a larger sum than you initially borrowed. The amount you pay back will depend on the interest rate you are offered by your mortgage provider, as well as the length of your loan. The higher the interest rate, the more you’ll pay back over the course of your loan and the more expensive your monthly repayments will be.

The Bank of England Base Rate

The Bank of England has an inflation target of 2%. This is intended to regulate the country’s finances and keep economic activity on an even keel. If supply and demand fall out of sync, the Bank of England makes adjustments to the base rate to try to influence the markets and bring things back into balance.

Mortgages providers take most of their cues from the Bank of England when calculating the interest on the loans they offer. If the base rate goes down, borrowers should find that their monthly payments also drops and better mortgage deals become available. If the base rate goes up, monthly repayments will increase and those arranging a mortgage will find that the deals on offer are more expensive.

Fixed terms

When you first arrange your mortgage, you’ll probably have an initial fixed rate period of two to five years. This means that the interest you pay won’t change during this time and you’ll pay back exactly the same amount every month. At the end of the fixed term, you’ll either re-mortgage or automatically be placed onto your lender’s default mortgage option.

Repayment mortgages

There are lots of different types of mortgage available, but the two main options available are repayment and interest only mortgages. If you choose a repayment mortgage, you’ll gradually pay back your initial loan, plus interest, over time. The longer you take to repay the loan, the more you’ll end up paying in interest overall.

Interest only mortgages

Some investors prefer to opt for interest only mortgages. This means that you only pay back the interest accrued on the loan, not the lump sum itself. This type of mortgage is often chosen by buy to let landlords as it minimises repayments and maximises income.

Tracker mortgages

The interest rate you’ll pay on variable rate and tracker mortgages can vary. Banks will often put their variable and tracker rates up and down in conjunction with Bank of England base rate changes, so your mortgage repayments will be influenced by the overall health of the country’s economy.

Interest rates can be incredibly complex, especially when it comes to mortgages. For help understanding the issue and how it relates to your home loan, contact a member of our expert team today.

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Written by: Editorial Team