How do mortgage interest rates work?

How do mortgage interest rates work? | YBS

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At a glance:

In simple terms, when you get a residential mortgage, you borrow money (called capital) and pay it back.

You’ll also pay interest on the amount you’ve borrowed.

How much you pay will depend on the interest rate of the mortgage deal you pick.

Why rate is important when picking a mortgage

The interest rate affects how much you pay each month and overall. A higher interest rate means your repayments are higher.

At the start of your mortgage, the amount you pay off the amount you borrowed (the capital) is low, as most of your repayment goes towards the interest.

As you carry on paying off your mortgage, you’ll start to pay off more of the capital.

The rate and type of mortgage you pick will depend on you and financial situation.

The bank of England base rate

You’ll also need to know about the Bank of England base rate.

This is the rate at which the Bank of England charges lenders, like banks and building societies, to borrow money.

Changes the base rate can mean your interest rate goes up or down. This only applies if you have a variable rate mortgage.

If you have a fixed rate mortgage, your interest rate will stay the same for the agreed term, even if the base rate changes.

Fixed rate mortgages

A fixed rate mortgage means your interest rate and monthly repayments stay the same throughout the agreed term. This is often 2, 3 or 5 years.

Benefits of a fixed rate

You will know what you monthly repayment will be.

What to think about

If rates go down, you won’t benefit. If you had a variable rate mortgage, your repayments may reduce.

Variable rate mortgage

Variable rate mortgages mean that the interest rate can rise or fall. For example, if the base rate changes, how much you pay with a variable rate mortgage will go up or down. A tracker mortgage is an example of a variable rate mortgage.

Benefits of a variable rate mortgage

If mortgage rates go down, your repayment could go down too.

Considerations with a variable rate mortgage

If rates go down, you won’t benefit. If you had a variable rate mortgage it you repayments may go down.

There may be a limit (called a collar) to how low your repayment can go.

Interest only mortgages

A interest only mortgage means that you only pay off the interest. At the end of your mortgage term, you will need to pay off at the capital at once. You will need to tell your lender how you plan to do this.

This makes interest only mortgages unique, as with all other mortgage types, you pay back the capital and the interest at the same time.

Benefits of an interest only mortgage

Your mortgage repayments may be lower than with a residential mortgage.

Considerations with an interest only mortgage

You need to be confident that you can repay the capital at the end of the mortgage.

Offset mortgages

An offset mortgage allows you to link your savings or current account balance to reduce your mortgage balance.

It works by reducing the amount you pay mortgage interest on. You will only pay interest on the mortgage balance amount minus the amount you have in your linked savings account.

For example:

Mortgage balance = £200,000

Savings balance = £25,000

Interest is charged on £175,000 only (£200,000 minus £25,000)