Mortgage Rates: How Interest is Calculated
Mortgage Rates: The Choices Available to You
Mortgage Rates are the biggest component of your monthly payment because your monthly interest payments will usually be larger than the monthly payments you make to pay off the loan.
This page outlines the main ways of calculating mortgage rates, which are determined by the type of agreement you make with the lender. However, there are many variations on those listed here, depending, for example, on whether the lender revises mortgage rates daily, weekly, monthly or even annually.
You may be able to see the importance of mortgage rates in your bank statement. If you are repaying a loan through endowments, you will normally see the payments from your bank account being made in two separate transactions: one for interest payments, and one for the endowment policy. The former, which reflects the mortgage rates you are paying, is usually much larger than the latter, which reflect the amount you are repaying of the loan.
However, with many loans the monthly payments are combined into a single bank account transaction. What you can't see is the hidden calculation done by the lender that separates interest from repayment. Nevertheless, the same principle still applies: mortgage rates are often a larger slice of the monthly payment than repayments.
Therefore, the choice of interest calculation - or mortgage rates - can make a big difference to the overall cost of your mortgage. These are the main options:
Tracker
Monthly payments can change frequently with tracker loans. This is because the monthly amount you pay goes up and down as interest rates go up and down.
The rate of interest used is usually set slightly above a base rate that is "tracked", such as the Bank of England's base rate. So, if the Bank of England's base rate is 4%, the mortgage lender may set their rate at 4.75%. Any change in interest rate is applied automatically, immediately or very quickly after the change, so the monthly payment changes also changes quickly.
Variable
This sometimes referred to as "standard variable", and the monthly payments can change occasionally.
"Variable" is similar to Tracker, except that the monthly amount you pay back does not go up and down automatically and immediately. It changes only as the lender decides. It may be left until the end of specified periods, sometimes as infrequent as annually. These are often the most expensive type of mortgage available.
Fixed
Fixed Rate Mortgages are usually offered for a specific number of years, and during that period your rate of interest, and therefore your monthly payments, do not change, irrespective of general interest rate movements.
After the initial fixed period, the interest usually becomes "variable" again.
Discount
Discounts can be offered on the above mortgages. They provide a discount - ie you pay less - for an initial period. These are usually variable rate mortgages, so the monthly payments can still go up and down in line with interest rates. However, you still pay less than you would otherwise have paid.
Capped
A cap can also be offered on the above mortgages. This is usually a special form of variable mortgage where rates can go up and down but, for an initial period of the mortgage, there is a ceiling. That is, there is a maximum rate above which your mortgage will not go. Your monthly payments will therefore vary, but never be greater that a certain amount (the 'cap') because if interest rates go above the cap, then you only pay the capped rate, not the (higher) variable rate.
Summary
Interest is calculated by one (or more) of the following methods:
Tracker
Variable
Fixed
Discount
Capped
See our main article for an overview of mortgage rates, repayments, and other features.
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