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Mortgage Interest rates: how do they work?

Mortgage interest rates can be a complicated topic to get your head around. Read on to answer any questions that you might have about them!

Mortgage interest rates have a massive influence on the amount that you pay back on your mortgage. In short, if you borrow money that must be repaid at a rate of interest of 3%, then it will cost you the amount that you borrowed plus 3% of that amount to pay it back. Doesn’t sound too complicated does it? Unfortunately, the problem with interest rates is that they can fluctuate. Interest rate rises can cause loads of problems for a shedload of homebuyers. No matter if it’s first time buyers or those remortgaging, interest rate rises can affect those not on the right mortgage deal. Let’s find out more.

How do mortgage interest rates work?

So, if you read that last paragraph and don’t quite understand why mortgage interest rates go up and down, let us explain. Most variable mortgage interest rates are set against a benched index rate. In England, this benchmark takes the form of the base rate set by the Bank of England. This means that if the base rate set by the Bank of England increases, then so too will interest rates and the same for if the Bank’s interest rates decrease too.

While this can be frustrating for buyers, particularly those doing it for the first time, it does have its perks. For example, if you are on a variable rate and your mortgage interest rate decreases then you will be paying less per month than you may have originally planned to.

An example of how mortgage interest rates work:

For those of you who are still racking their brains on how all of this works, we’ll give you an example. If you borrow money from a mortgage lender at a rate of 5% on an amount of £10,000 to be paid back in a year, this means that you’d pay £500 (5% of £10,000) extra on top of the £10,000 you borrowed.

What types of mortgages deals can I get?

If you’re worried about bearing the brunt of fluctuating mortgage interest rates, there are ways around this. Fixed rate mortgages are a popular option for those concerned about future interest rate movements or who are looking to budget their monthly payments accurately. For example, if you are on fixed rate mortgage then this will mean that if mortgage interest rates increase or decrease then yours will stay the same as it would be ‘fixed’.

This can be an attractive proposition for those making their first step into the property market. This is because it will allow them to plan for the term that their fixed mortgage runs without fear of a sudden monthly payment hike. The only problem with this is that while a fixed mortgage interest rate will provide you with more consistent outgoings and protect you from mortgage rate increases, it also means that if they drop then you will not benefit from this either. 

Why are some mortgage deals better than others?

Any deal or mortgage interest rate, which will be offered to you by a lender, will be largely dependent on your credit score. This is to check whether you have a good track record of repaying any previous debts and ultimately if you are a responsible borrower. If you have a poor credit score then most lenders will either decide against lending you money or do so at a higher interest rate.

Due to the risk that you may pose to them by having a poor credit score, lenders will only lend money under the guise of a bad credit mortgage. This means that higher interest rates are used to help mitigate the risks involved with lending to someone with bad credit.

The other main factor determining the rate you could be offered is the level of equity you have in your property or, if you are purchasing, the amount you have available for deposit. The cleaner your credit & the higher your equity / deposit then the safer the lender feels & so the rate offered becomes more competitive.

What is APR?

The likelihood is that if you’re talking about mortgage interest rates you’ll have heard phrases like ‘APR’ being thrown around. APR (Annual Percentage Rate) is something that lenders advertise when you borrow money from them. This deviates from a standard mortgage interest rate. How? This is because it will take into account your mortgage interest rate and any other fees that are included within your loan amount. This can take the form of booking & arrangement fees. Basically the APR is what the money is costing you inclusive of all fees the lender is charging.

What is AER? 

AER (Annual Equivalent Rate) is basically the official rate for savings accounts. This is put in place to make the lives of savings account users much easier. Why? This will allow for easy comparisons as it is supposed to signpost the key differences between savings accounts. This is done by the AER signalling to you what you would be getting over a year if you were to leave a sum of money in an account left untouched. This can also come in the form of a gross rate. This is basically your total rate of return before the reduction of any fees or charges that you may incur.

What are compound interest rates?

Compound interest rates are slightly more complicated. This is basically where interest is earned not only the amount that you borrow but on any interest that there is as well. As a result this compounds. Sounds pretty confusing doesn’t it? Let’s have a look at an example.

So, let’s say that you have £1,000 stored in a savings account that is increasing at a rate of 2% interest per annum then at the end of your first year you will have £1,020. Then from the next year you will be earning 2% of the new £1,020 amount. This means that you will have £1,040.40 at the end of your second year (2% of £1,020). With mortgages this obviously works in reverse to some extent as you are borrowing money rather than depositing it into a savings account. In mortgage terms it means that you are paying interest on the interest a=being added to your mortgage. 

What we can do for you at Mortgages.Online:

At Mortgages Online we appreciate that getting your head around all of this information can be a real headache. But don’t worry. If you feel like you have any more questions about mortgage interest rates or interest rates in general, then you can check out some of the other articles on our website. Since it’s free to use there’s nothing stopping you. So have a browse!

If you want to learn more about standard variable rate (SVR rate) mortgages, interest-only mortgage and loads more, click to our Articles section. At MO our advice and services are free, so no need for you to use your credit card.


Laura Waller

Laura Waller has been working in the mortgages industry since 2013, joining an independent brokerage in Essex. Laura has CeMAP 2 & 3 – Certificates in Mortgages Advice and Practice. Since then Laura oversees marketing for Mortgages Online, using her experience and expertise to write articles and blogs about mortgages and related topics.

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