How Do Mortgage Interest Rates Work?

Your mortgage interest rate is one of the most important factors to consider when buying a home - so how does it work?

Interest is charged on every pound you borrow, so the higher the rate, the more you’ll pay back.

With this in mind, it’s a good idea to understand the different types of mortgage interest rates, how they’re calculated and charged, and what can affect the rates you’re offered.

How is Mortgage Interest Calculated?

Your mortgage interest rate is calculated as a percentage of your loan.

If you're charged 3% interest per year, you'll need to pay 3% of the value of your loan each year to your lender.

For example, a £100,000 loan at 3% interest costs £3,000 annually.

As you gradually repay your mortgage, you usually pay less interest because the amount you're borrowing decreases as you pay it back, so there's less interest to pay.

Several factors affect how high or low your interest rate will be, including:

• your credit score
• your deposit amount
• the type of mortgage you have
• and the duration of your mortgage

Here’s a simplified example of how mortgage interest rates work:

• You borrow £145,000 over 25 years
• You choose a fixed-rate mortgage
• And your interest rate is 5%
• Your monthly mortgage repayment will be £848
• This will consist of £365 of capital repayments (paying back the actual loan) and £483 of interest accrued on your loan*

As a comparison, here’s the same example with an interest rate of 4% instead:

• Your monthly mortgage repayment will be £765
• The capital repayments chunk of this will be the same, at £365, but your interest repayments will be lower at £400
• This difference will save you almost £25,000 throughout your 25-year mortgage*

*figures used are for example purposes only

By the end of your mortgage payments, you'll own your property and have paid a significant amount in interest. It's important to note that generally, the longer your term, the more interest you’ll pay.

See similar: Is Switching Lenders Really Worth It?

What Are the Different Types of Mortgage Interest?

There are two main types of mortgages defined by their interest rates, these are:

Fixed-Rate Mortgages

As per the example above, fixed-rate mortgages have a static interest rate. Whatever rate your lender agrees upon is the amount you’ll pay throughout your product term.

This benefits budgeting and knowing precisely what your mortgage will cost you each month.

And, if interest rates rise across the market, your mortgage rate will stay low.

On the other hand, if rates go down across the market, you could pay more than some other options.

Variable-Rate Mortgages

The alternative is a variable-rate mortgage. Your interest rate on a variable mortgage can change throughout the term of your deal, be that through the Bank of England’s base rate or your lender’s specific criteria.

Your mortgage payments could fluctuate over time, making it harder to budget. But, you could save money if interest rates across the market are reduced.

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What Are Tracker Mortgages?

Another type of mortgage worth mentioning is a tracker mortgage. These are variable-rate mortgages that " track” the Bank of England’s base rate when setting the interest rate.

When the base interest rate goes up, so do your monthly repayments – likewise, if the base rate goes down, your mortgage payment will follow suit.

For example, a tracker mortgage of 0.75% will always have an interest rate of 0.75% above the base rate, however much it fluctuates.

If you need help deciding which type of mortgage is best for you, read our guide on the pros and cons of fixed and tracker mortgages and how to decide.

What Can affect your mortgage interest rate?

There are a few key factors regarding a lender’s policy regarding interest rates.

Lenders are mainly influenced by the base rate (which most banks follow closely). But there are several other factors for which lenders can differ greatly:

Lender Competition

In a competitive market, most lenders want an edge.

Pricing in the mortgage market and the interest rates set are often influenced by the general movement of competing lenders. For example, a bank may alter certain offers or deals based on other lenders in the market to remain competitive.

Funding

Another key factor is where the lender gets their money from. Lenders source funds through various methods – the money lent to you for a mortgage may be borrowed from elsewhere.

Also, lenders must consider expenses; their capital and liquidity will affect whether they raise or lower interest rates on the mortgages they offer.

Risk

Ultimately, lenders must consider the risk of lending.

There is always the possibility that a borrower may default on their mortgage repayments, so lenders need to mitigate any potential loss. This is done partly through your LTV (Loan-To-Value) ratio, which is the value of your mortgage displayed as a percentage of your property value.  

The lower the LTV of your mortgage, the lower your interest rate will be.

How Does Your Deposit Affect Your Mortgage Interest Rate?

This means that the higher your deposit, the better your LTV and the better interest rate you could get.

Some lenders provide mortgages up to 95% LTV, so you only require a 5% deposit. But you’ll probably pay higher interest rates to compensate for this.

The bottom line? The more money you can put towards your house purchase, the cheaper your mortgage will likely be.

Related: First Time Buyer Mortgage At 5.5 Times Salary Now Available

What Else Can Affect the Interest Rate You Get?

Aside from a lender’s overall policy and your LTV, a few other factors can affect your mortgage's interest rate.

These factors are based on the financial circumstances of you, the borrower:

Credit Score

If you have a poor credit history or several unpaid debts, the interest rate you are offered will reflect this.

A lender will see it as a concern and potential risk, and they’ll increase the interest rate in response. Conversely, if your credit history is clear, you may have access to lower rates.

Loan to Income Ratio (LTI)

Your employment (or self-employment) is used by lenders to determine if you can keep up with monthly mortgage repayments.

The more you earn in comparison to the size of your loan, the cheaper your interest rate is likely to be.

The general rule of thumb is that you can borrow up to 4.5 times your annual income. But there are ways to borrow more than 4.5 times your salary.

You may also see this term expressed as your debt-to-income ratio (DTI). This is a similar calculation, but it also considers any other debts you have, from credit card balances to personal loans or other mortgages.

Here are some rates we secured for our clients recently

Residential

*Overall Cost For Comparison 

Buy to Let

How Can You Borrow More With Your Mortgage?

There are five key things to look at to get a bigger mortgage:

• Your credit score
• Your annual income
• Your employment type
• Additional security for your loan
• Your deposit size

To estimate your maximum mortgage size, check out our mortgage calculator.

Watch our video on how to maximise your mortgage for more tips:

Related: How Much Can I Borrow?

How Do You Get Low Interest Rates on Your Mortgage?

You may want to speak with a mortgage adviser if you're considering a mortgage on a new property.

In addition to banks and building societies, our experienced brokers also compare rates from private and specialist lenders that are not typically available to the public.

They can help you compare the pros and cons of the wide variety of options before you and then negotiate the best interest rates on your behalf.

To see what we can do for you, call us on 0117 313 5980 or book a free consultation below.

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