The interest rate on your mortgage is simply an expression of how much interest you’re being charged on the money you’ve borrowed.
It has the power to make a huge impact on the amount you pay overall and the size of your monthly payments.
How Are Mortgage Interest Rates Worked Out?
When considering how mortgage interest rates are worked out, it is helpful to break things down into two steps.
This is the interest rate that a bank publishes online or in its literature and is supposed to give customers an idea of how much a particular mortgage would cost.
The advertised rate is influenced by a whole host of different factors in the wider economy. One of the most important factors is the Bank of England’s base interest rate, and most advertised interest rates will follow the Bank of England base rate in some way.
If the base rate goes up or down- or even if there are just rumours of a change- lenders may alter their advertised rates to reflect that.
The unemployment rate and economic forecasts are also used by lenders to determine how risky it is to be lending. For example, if unemployment is rising, lenders may start to charge more interest, to offset the risk that some of their customers won’t be able to repay their loans in the future.
After considering all of these factors, lenders advertise a mortgage rate which they hope will entice mortgage shoppers to borrow with them, while still being profitable.
Unless you have an excellent credit rating, you are unlikely to get the interest rate that is advertised by a lender.
In reality, many of us carry additional risk factors as borrowers which will cause a lender to want to charge us more interest. These risk factors are represented in our credit score.
By looking at your credit history, a lender can get a picture of your past financial behaviour and use this to determine how risky it would be for them to lend you money.
If you have a good credit score and clean report, the lender assumes you’re very likely to be able to repay them in full and on time and will be able to offer you lower interest rates.
On the other hand, if your credit rating is at the lower end of the scale, you could find yourself facing interest rates which are much higher than the ones advertised by the bank.
Your deposit also plays a role in the interest rate you’ll be offered.
Generally speaking, lenders prefer deposits of at least 25%. In industry speak, deposits are often talked about in terms of the ‘loan-to-value‘ ratio, or LTV. This is how much deposit you can offer in relation to the total value of the house. So, a 25% deposit would have an LTV of 75.
Although it is possible to get a mortgage for an LTV as high as 95, the lowest interest rates will be for people whose deposit has an LTV value of 75 or lower.
If you already have a mortgage and are looking to move to another deal, you can improve your ‘deposit’ by paying off some more of your current mortgage, increasing the equity on your home.
Why Are Mortgage Interest Rates Important?
Your mortgage interest rate will determine how much you pay overall and how much your monthly payments are.
For small loans, it is possible (though not advisable!) to overlook high-interest rates without feeling too much of a sting.
However, when you take a mortgage, you borrow a huge amount of money over 20+ years, during which time interest has plenty of time to mount up. For this reason, the interest rate on your loan can end up having a pronounced effect on how much you end up paying over the years.
For example, let’s consider the effect of interest rates on a £150,000 mortgage paid over 25 years. At 3% interest, your monthly payments would be £711, and overall you would end up paying back £213, 395.
At 4%, just one point higher, your monthly payments would shoot up by £81 per month to £792, and you would end up paying back an extra £24, 132 overall.
Different Kinds of Mortgage Interest Rate
Different mortgages calculate interest in different ways. By understanding how each of these types works, you can make an informed decision about which one is right for you according to your budget, motivation and tolerance for risk:
In a fixed-rate mortgage, your interest rate is set at the beginning of the contract and doesn’t change for the duration of the ‘introductory period’, normally two to five years.
This means that you know exactly how much you need to pay each month and won’t ever be caught out by a sudden rise in interest rates. However, if interest rates fall, you’ll lose out on the savings that homeowners with a variable rate mortgage make.
At the end of the introductory period, you are moved onto your lender’s ‘standard variable rate mortgage’. This typically has a slightly higher interest rate, which can change from month to month.
Variable Rate Mortgages
There are different kinds of variable-rate mortgages. The thing they all have in common is that the interest rate on the mortgage can change from month to month, meaning that monthly payments can go up and down.
Some variable-rate mortgages come with a ‘cap’ or a ‘collar’. These are upper and lower limits to how far the interest rate can change.
You should be aware of these if you’re shopping for a variable-rate mortgage, as they can either help make your monthly payments more predictable.
Standard Variable Rate Mortgages (SVR)
SVR mortgages are a no-frills mortgage with relatively high-interest rates. Every lender has their SVR interest rate, which they decide on and can change at any time.
This means that payments can go up and down without notice (although often, lenders are guided by changes to the Bank of England’s base rate). SVR mortgages tend not to be very competitive and frequently charge the highest interest rate of any of the lender’s mortgages.
However, they normally have no exit or early repayment fees, so you won’t pay to remortgage or move to a new plan.
Tracker mortgages are a type of variable mortgage where the interest rate follows the movements of another interest rate, at a fixed margin above it. Most commonly, the interest rate which is tracked is the Bank of England’s base rate.
For example, if you held a 3% tracker mortgage, your interest rate would always be 3% higher than the Bank of England’s base rate; so if the base rate were 0.5%, your mortgage’s rate would be 3.5%.
The base rate can change up to eight times a year, although in practice it is rare for it to change so frequently.
The tracking period is normally offered as an introductory discount lasting from two to five years. At the end of this period, you are moved onto the lender’s standard variable rate mortgage.
A discount mortgage follows the movements of a lender’s standard variable rate (SVR) at a fixed margin below. The SVR is an interest rate which is set by the lender and which they can change at any time. This means your mortgage payments can suddenly change, but you are guaranteed never to pay as much as someone on an SVR mortgage.
For example, if you had a 2% discount mortgage, your interest rate would always be 2% lower than the lender’s SVR; so if the SVR were 4.2%, your interest rate would be 2.2%. If the SVR rose to 5%, your interest rate would be 3%.
When the SVR falls, discount mortgages can offer seriously low-interest rates. However, some deals come with minimum ‘collars’, meaning your interest rate can’t fall below a certain level, no matter what happens to the SVR.
Discount mortgages normally last for between two to five years. At the end of this temporary period, you are moved onto the lenders SVR, meaning your payments will increase.
How Can The Mortgage Bank Help?
Here at The Mortgage Bank, we have partnered with some of the UK’s leading mortgage brokers.
They have already helped thousands of people get the best remortgage deal even people that have been refused before, and they can do the same for you.
Choosing an independent adviser means they won’t recommend a scheme unless they are sure it is in your best interests. Their advice is also regulated by the FCA, which gives you an additional layer of protection.
If you would like to speak to one of these brokers who can provide you with a ‘whole market quote’ then click on the below and answer the very simple questions.