As discussed in An Overview of How Mortgages Work and Their Regulation in the UK, a mortgage, simply, is a loan specifically tied to a piece of property. The property essentially serves as collateral, as the mortgage provider has the right to repossess it if the payment is defaulted. In this article we look at:
- How mortgages are commonly repaid
- Alternative ways to repay mortages
- Understanding interest and interest rates
- Deciding to take out a mortgage
How mortgage interest rates are determined and compounded
Mortgages are often repaid with interest in monthly installments that can last as long as 25 years, or even longer as discussed here. One in six borrowers, in fact, have chosen to take out longer-term mortgages that can be repaid in 35 years or more. This means that 15.75% of all new mortgages will be repaid by borrowers who are well into their retirement.
Theoretically, a longer-term seems easier on the pocket, as monthly payments are generally lower, with the debt spread out over several more years. In reality, however, a longer-term can actually be a burdensome alternative, partly because the repayments extend into retirement age, and largely because of how the added interest drastically increases the total amount that will be paid.
In other words, the £10,500 interest you would pay for a 5-year loan might balloon to £12,500 if extended to 10 years; £17,000 if extended to 20 years; and £21,500 if stretched to 30 years. Of course, that is just an example to clearly illustrate why the Bank of England has grown concerned over the increase in the number of long-term loans.
Understanding interest and interest rates
Interest is simply your payment for the money you have borrowed, and it is through this mechanism that the lender makes a profit. How much you pay is determined by the interest rate or the percentage of the principal charged by the lender for borrowing the money. It is what makes loans expensive, especially when the interest rates are high.
A country’s central bank sets interest rates, and it does so with an eye on inflation. The Bank of England has an inflation target of CPI – 2%+/-1, and this simply means that it wants inflation close to 2%.
So, if the inflation is higher than the aforementioned target, the Bank of England will likely set higher interest rates to increase the cost of borrowing and discourage consumer spending, which slows down economic growth, but stabilises inflation as a trade-off. In contrast, the Bank of England will lower interest rates if inflation is below the target to boost spending and spur economic growth. Naturally, the central bank keeps track of inflation indicators like wage rates and consumer spending levels.
Do the maths
Computing for simple interest is relatively straightforward. Take this scenario, for instance: You borrowed £1,000 from a bank at 12% per annum. In this scenario, the £1,000 is the principal, or the present value, while the 12% is the interest rate. The interest in this example is 12% of 1,000, or 12 hundredths of the capital. To compute, simply multiply 1,000 by 0.12, and the total — £120 — will then be the interest. If the loan in the same scenario is payable in three years, the total interest will be £360 – £120 at the end of year 1, £120 at the end of year 2, and £120 at the end of year 3.
Things get a bit more interesting when interest is compounded. Here, there is interest on the original interest. This interest is then added to the principal at the previous year’s end. The following year’s interest is then computed based on the higher principal. Let’s go back to the example in the previous paragraph, retaining the exact same scenario but changing simple interest to compound. At the end of year 1, £120 will be added to the principal, making it £1,120.
Interest is simply your payment for the money you have borrowed, and it is through this mechanism that the lender makes a profit.
For year 2, the interest will be 12% of £1,120 (principal + interest of year 1). At the end of year 2, therefore, the principal will be £1,254.40 (£1,120 multiplied by 0.12). For year 3, the interest will be 12% of £1,254.40 (principal for year 2 + interest of year 2). At the end of year 3, the principal will be £1,404.93 (£1,254.40 multiplied by 0.12). So, after 3 years of compounding interest, the bank would have earned £404.93 as opposed to only £360 with simple interest.
Time to get a mortgage?
Mortgage interest rates have steadily climbed in the UK. Nevertheless, now might actually be a good time to take out a mortgage on property, with the UK housing market registering a low reading on FXCM’s comprehensive Economic Calendar.
This means that the market is currently in a rut, with house prices on a continuous decline largely due to restrained levels of new buyer enquiries, and the lack of properties on the market. Now, should you decide to take out that loan, just make sure you cover your bases and check up on all matters related to interest rates.