How is Interest Calculated on a Mortgage?

Interest on mortgage graph and calculator

Applying for a mortgage is a significant milestone in a person’s life, but before you sign on the dotted line, you need to be sure that you’re getting the best deal for your current situation.

Your ideal home probably costs hundreds of thousands of pounds, so you will inevitably need to borrow a considerable amount of money from a lender. As a mortgage is a type of loan, interest will be charged on the amount you owe.

How much you’re charged to borrow from a lender depends on the mortgage interest rate you receive, which is determined by a wide range of factors.

How is mortgage interest calculated in the UK? Here’s a list of 6 key factors that influence the mortgage interest rates you will be offered when you look to buy a home.

1. LTV (Loan-to-Value) ratio

Firstly, what is an LTV ratio? The loan-to-value (LTV) ratio is a percentage that represents the ratio between the value of the loan you apply for and the value of the property you’re buying. The remaining percentage – for example, 20% if your LTV is 80% – is how much you’ll have to pay as a deposit.

For example:

The house you want to buy is worth £250,000 and you have saved a total of £40,000 to put down as a deposit. You will need a mortgage loan of £210,000 to buy the property (the property’s value minus your deposit). £40,000 would be a 16% deposit, meaning that your LTV is therefore 84% (as £210,000 is 84% of £250,000).

Mortgages are available with LTV ratios between 60% and 100%, with an LTV below 80% considered ‘low’ and anything above 85-90% considered ‘high’.

Low LTV mortgages come with low interest rates but high deposits, whereas high LTV mortgages mean lower deposits but higher interest rates.

The larger your deposit is, the lower your interest rate will typically be, which is why it’s so important to save as much as possible before looking to buy a home.

People who put a 40% deposit down will be eligible for far lower (and more competitive) interest rates than someone who has only saved a 10% deposit, for example.

As is so often the case with any type of lending, the interest rate you receive is essentially down to the risk you pose.

Borrowing with a high LTV (low deposit) means that you will not have much equity in the property – i.e., you won’t own a large proportion of the home – meaning it is more likely that the lender will make a loss if you default the loan or the property value decreases.

If you want to calculate your own loan-to-value amount accurately, you may benefit from using a mortgage LTV calculator.

2. The mortgage lender you choose

It’s somewhat out of your control, but one influential factor in determining the interest rates on offer is the level of competition in the market at that time.

Mortgage lenders frequently evaluate the market to determine what interest rates they should set, so it’s important that you shop around a little to find out which companies are offering the most affordable rates.

When deciding on a lender, you should look for providers that combine the best interest rates, customer service, and reliability.

3. Your credit history

Your credit report is essentially a record of how you have handled credit in the past, including personal loans or credit card repayments.

As a rule of thumb, the better your credit score is, the lower (and therefore better) mortgage interest rates you will qualify for.

If you have a poor credit score (by missing loan repayments or failing to build a credit history, for example), you may not be eligible for the very best interest rates on the market.

In fact, some lenders will even refuse to offer you a mortgage at all if your credit score is well below average, due to the additional risk you pose as a borrower.

This is why it’s imperative that you keep an eye on your credit rating and try to improve your score before applying for a mortgage.

>> You can check your credit score today with Checkmyfile – the UK’s leading credit reporting website that offers an insight into all four main credit reference agencies <<

4. The deposit you put down

As mentioned, putting down a higher deposit generally means that you will pay less in interest.

So, in order to ensure that you gather enough money to put a large deposit down (which will lead to a low LTV), you must start putting savings aside as early as possible.

You should also make full use of the specialist savings accounts available in the UK which can provide valuable boosts, such as the Lifetime ISA (which provides a 25% government bonus on top of whatever you save when you use it to buy a home, up to £4,000 a year).

You might like: Save Smart With UK Savings Accounts

5. The term – how long your mortgage lasts

When you apply for a mortgage, you also need to determine how long you will need to pay it off – i.e., the ‘term’.

Standard mortgage terms are generally 25 years, but in some cases, you may be able to get one that last as little as 6 months or as long as 40 years.

Which option you choose depends on your personal needs and circumstances, but most homebuyers tend to opt for the middle-ground of 25 years.

The benefits of long-term mortgages (anything above 25 years) are that monthly payments are cheaper and increases to interest rates have less of an impact on the amount you pay. They do, however, take longer to pay off (as you’d expect) and can be more expensive overall as more interest is usually charged.

Short-term mortgages can be cheaper overall because you will be charged less interest, and you will pay off your debt in less time, but that usually means far higher monthly payments, which can be unfeasible unless you’re on a very high wage.

6. The type of mortgage you choose

There are many different types of mortgages available in the UK, including:

Repayment mortgage
Interest-only mortgage
Fixed rate mortgage
Standard variable rate (SVR) mortgage
Discounted rate mortgage
Tracker mortgage
Capped rate mortgage
Cashback mortgage
Flexible mortgage
Offset mortgage

Each type of mortgage has its pros and cons, but the most common in the UK is the conventional fixed-rate mortgage. This type of mortgage loan provides borrowers with a fixed interest rate for a set amount of time, usually 15 or 30 years.

The vast options available can be overwhelming, so the first choice to make is whether you opt for a fixed or variable rate mortgage. Once you make that decision, you can begin the process of elimination until you find out which type of mortgage best suits your circumstances.

Mortgage lender fees

Many mortgage lenders charge application or product fees on top of the interest that you pay, which can amount to around £1,000 in total.

These fees can either be added to your mortgage balance and paid monthly, or you can pay them up-front as a lump-sum. Including the cost of product fees within your mortgage balance would lead to interest being added, so it’s usually worth paying it up-front if you can afford to do so.

Some lenders offer special products or deals with zero fees, but be aware that these generally come with higher interest rates.

For example, a typical mortgage product might come with a 2.09% interest rate and a £1,000 product fee, while the alternative fee-free version may be on offer with a slightly higher interest rate of 2.34%.

There is no universally right or wrong option, so it’s important that you weigh-up the total cost for your personal situation before committing to a loan.

How mortgage interest is calculated

There is a range of factors taken into consideration when determining the cost of your mortgage and the interest you’ll be charged when paying it back, but it’s important to note that a few of them are within your control.

You can, for example, build a credit history from an early age to develop a strong credit score, which will go a long way in increasing your chances of being accepted for a more competitive mortgage.

For more information on relevant topics, be sure to read our related guides:

buying a house