The Basics Of Mortgages And Interest Rates

I’ve said it before and i’ll say it again (until I’m blue(r) in the face), a mortgage can ultimately determine the success or failure of a property investment. My point being? It’s imperative that you understand how mortgages work so you are able to get the best deal available on the market, without getting wool pulled over your eyes. I read this article a week or so ago, “Borrowers do not understand different rates” (link was removed because the article has been removed from hotproperty.co.uk).

Quick Breakdown of article:

New research from Nationwide has found that three quarters of Britons are unable to explain the difference between a five-year fixed-rate mortgage with a rate of 5.6 per cent and one with a rate of 6.6 per cent.

The lender has revealed that 16 per cent of those aged 18 to 24 were able to work out the financial difference between the two mortgages, compared with 31 per cent of those aged 55 to 64.

That’s quite a worrying statistic. The fact that borrowers are unaware of such a major player (interest rates) in borrowing makes me think the following:

  • It’s no wonder people are getting repossessed
  • If borrowers don’t know the difference between 5.6% and 6.6%, then they’re probably unaware of the difference between fixed/variable rates. That can be worrying if someone is on a fixed rate and oblivious to the change in rate once it kicks into a variable rate
  • people are so desperate to get onto the property ladder than they’ll sign away their life if they have to

How Interest Rates Work with Mortgages

When kept simple, interest rates are pretty straight forward. To get to grips with interest rates it’s easier to work with small numbers as opposed to hundreds and thousands. Essentially, if you’re borrowing money with an interest rate of 1%, it means for every £1 you borrow, you will pay back an extra 1% of that £1, which will be 1pence (total £1.01). So if you borrow £1 with an interest rate of 5%, you will pay back an extra 5%, which will be 5pence (total £1.05).

Those examples only illustrate how interest rates work on a very simple scale; it gets more complicated with mortgages.

The basics of Interest Rates in reality

Lower the interest rate, the better- 5.6% is better than 6.6% when you’re borrowing. I know that may sound simple, but it obviously isn’t THAT simple. I know there was a time when the difference in rates meant nothing to me.

The 1% difference can be substantial and can literally save you an arm and two legs. If you’re borrowing 150k over 25years with a 5.6% interest rate, you’ll pay £282,294 approx in total. If you’re borrowing the same amount with the same life-span, but with a 6.6% interest rate, you’ll pay £310,278 approx. That tiny 1% can potentially save you £27,984 over a period of 25years.

That’s a small fortune, and like I said, with that much you can pay for your bionic limbs. Always try and get the lowest interest rate possible; you’ll never know when you’ll need that leg.

The affects of Interest Rates when reducing your mortgage balance

Mortgages are large loans, so you won’t be paying them off in one huge payment. Reality is that you will spend a large position of your life paying off your mortgage (e.g 25 years) on a monthly basis.

If you borrow £100k over 25 years with an interest rate of 1% it doesn’t mean you will pay back 1% of £100k (£1k).

How it works is that the amount you pay interest on reduces as your outstanding balance reduces. So if in the first month of your mortgage you pay 1% of 100k and then you make a repayment of £300, the following month you will pay interest on £99,700. A mortgage repayment scheme is based on that structure.

Calculate Interest Rates on a Mortgage

You can use my Mortgage Calculator to work out how much Interest Rates will cost you. You can calculate various costs for different interest rates.

Be aware of changing rates

If your policy has a fixed rate period, make sure you find out when it expires and how much your variable rate will start at. In most cases your new rate will be substantially more. So for example, if you start off with a fixed rate of 5.5%, after 3 years it could change to 7.7% variable rate. You could find that your monthly repayment of £931.86 increase to £1141.12.

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