Interest is a fact of life for anyone with a loan of any kind, but with a high-value, long-term loan like a mortgage it takes on a special meaning. It’s important to understand that when you choose your mortgage, the interest rate is one of the most important components which determine what you pay monthly.
The rule is the higher your deposit, the lower your monthly payments; in other words, the more cash you have to put down as a deposit, the better chance you have of securing a lower interest rate. To be eligible for the best rates, you need a minimum of 40 per cent of the value of the property you want to buy. This is what is called ‘loan-to-value’ (LTV) and it means that with a 40 per cent deposit you have a 60 per cent LTV, enabling you to borrow 60 per cent of the price of the property you want to buy.
A mortgage with a 90 per cent LTV means that you’ve got 10 per cent to put down as a deposit for the purchase of the property. Traditionally 90 per cent mortgages have been the most expensive over the long-term, but mortgage rates have been falling and the cost of 90 per cent LTV rates have followed suit.
Mortgages and the interest rates tied to them are not based on autonomous decisions by particular lenders; instead they are based on complicated formulas and calculations that have to take several factors into account.
Your interest rate partly depends on decisions by the Bank of England. The interest rate depends on what the Monetary Policy Committee decides is the monthly base rate, which lenders use to calculate their interest rates. The base rate decided upon is calculated so that it can best meet the inflation target.
Your interest rate is determined by the amount of money you put down as a deposit and the base rate decided by the Bank of England, as well as your bank’s rates (Libor). Your lender gives you an annual rate which is then divided by 12 into monthly units and you pay it on the principal balance – the amount of money owed on the property. For the first couple of years all you’re essentially doing is paying off the interest; it’s only later on that you start eating into the actual property price.
Banks use what is known as the amortisation formula to make sure that every month the total amount that you pay on the interest and principal is the same. This is the calculation for what is called the fixed-rate mortgage, but it works somewhat differently for the adjustable-rate mortgage.
Adjustable-rate mortgages are mostly the same as fixed-rate mortgages, except for the adjustment factor. Basically, the monthly interest rate fluctuates, and each time the interest rate goes up or down your payment is adjusted so that your repayment schedule is on track until the principal amount has been repaid.
Note that your repayment schedule isn’t only based on interest charged, but also on the payment of the fees involved in the transaction. This is called the APR or the annual percentage rate, which is the added costs of your transaction with your lender, such as origination fees, application fees and prepaid interest points. This rate is what tells you what your interest rate will be with all the additional costs added, and is always higher than the stated interest rate. The APR is a good comparison tool for loans when you’re shopping around for a mortgage provider preparatory to buying a home.