How do Mortgages and Interest Rates work?

When you take out a mortgage to buy a property (typically as your primary place of residence), your chosen lender will generally lend you up to 80% of the cost of the mortgages; the loan-to-value (LTV). From here you enter into a contract whereby you pay back the money you were lent each month, with interest added.

Additionally, if the property is your primary residence, the mortgage is deemed a regulated mortgage contract and will be a first charge mortgage. This means that as the borrower, you are provided with more favourable interest rates. The longer you take to pay back your mortgage, the more interest you will end up paying. The short-term benefit of slowly paying back your mortgage is that your monthly payments will be lessened.

As you start to pay back your mortgage, the less you owe and thus the amount of interest you pay decreases. If you are able to pay back your mortgage quickly, you end up paying less overall than someone who pays interest for years and years.

How is Interest Calculated on a Mortgage?

Interest is essentially the monetary cost of using a lender. Interest rates are for the most part based on the Bank of England’s Base Rate. In the case of mortgages though, the provider will offer you a yearly interest rate. You can divide this amount by 12 in order to work out the interest you pay monthly.

For example, if you are looking to take out a mortgage on a property that costs £500,000, and you are offered an initial interest rate of 2.69% (fixed for three years), your initial monthly cost will be £2,291.23.

Types of Mortgage Arrangements

There are many different types of mortgage, and it can be difficult to remember which is which. Here is a comprehensive list in order to debunk the various types of mortgage that are available:

  • Repayment mortgages
  • Interest-only mortgages
  • Fixed rate mortgages
  • Variable rate mortgages
  • Tracker mortgages
  • Discounted rate mortgages
  • Capped rate mortgages
  • Cashback mortgages
  • Offset mortgages
  • 95% and 100% mortgages
  • Flexible mortgages
  • First time buyer mortgages
  • Buy to let mortgages

Popular Mortgage Types

Depending on a borrower’s circumstances, payment preferences and affordability, the most suitable type of mortgage will vary. For example, bridging finance is suitable for cases where other types of property loans may not be suitable or available. The same applies for primary mortgages [those for the property the borrower is using as their primary residence.] However, there are many forms to consider:

Repayment Mortgages – Repayment mortgages are the ‘standard’ type of mortgage, where you pay off a portion of the money you borrowed (plus interest) monthly. When you have finished paying off the loan, you are the full owner of the home.

Interest-Only Mortgages – Interest-only mortgages are where you only pay the interest amount monthly, and pay off the actual loan amount (minus interest) at the end of the loan period when you have accrued enough money to do so.

Fixed-Rate Mortgages – Fixed-rate mortgages are when your mortgage rate is fixed for a number of years. Rates are typically fixed for 2, 3 or 5 years, although some providers offer up to 10. When a mortgage rate is fixed, it means that the amount of interest you are paying does not change for that amount of time; you are exempt from rising or falling rates for the period agreed.

Variable Rate Mortgages – A standard variable rate (SVR) is where mortgage rates change in accordance with the rise and fall of interest rates. This is essentially the opposite of a fixed-rate mortgage.

Capped Rate Mortgages – A capped rate mortgage is where a limit is applied to how much your interest rate can rise, enabling you to avoid any surprise rises. Your rate will still go up and down with the market, but it will not rise over a certain amount.

Tracker Mortgages – Tracker mortgages move in accordance with a nominated base interest rate. When the Bank of England base rate goes up or down, your mortgage rate goes up or down by the same amount.

Discounted Rate Mortgages – Discounted rate mortgages are when a discount is applied to the SVR of a lender. As the name indicates, these are likely to be the cheapest deals, but the amount changes as with SVR and so you could end up paying more (or less) than if you had a fixed-rate mortgage.

Cashback Mortgages – This is a deal in which a percentage of your mortgage loan is given to you in cash. Cashback mortgages are less popular than they used to be, but they are good for people who need money upfront.

Flexible Mortgages – Flexible mortgages allow you to divert from the typical monthly payment schedule. You have the freedom with a flexible mortgage to pay off a larger amount as a one-off if you come across a period of financial luck, for instance. Flexible mortgages often come with a higher mortgage rate than other mortgage types.

Buy to Let Mortgages

Buy to let mortgages are for property-owners who choose to rent out their real estate rather than live in it themselves. The landlord or homeowner will pay the mortgage whilst obtaining rent from the tenants, and will borrow an amount that is reflected by the rent they charge. There are however, alternative that prove popular with investors including auction finance and others.

Each mortgage type has its own benefits which reveal themselves depending on circumstance. First-time buyers, for example, are likely to benefit from a fixed-rate mortgage or a capped mortgage as it allows for more accurate budgeting than if your mortgage rate were in flux. Cashback mortgages are typically attractive for people who need a cash loan, perhaps to help them get on their feet in their new home, for instance. It is important to compare mortgage rates with different providers in order to get the best deal.