How Is Your Mortgage Interest Calculated?

You might think this is a strange question and be of the opinion that it is calculated the same way as everyone else’s. Well the fact is that how your lender calculates the amount of interest that you owe can make a significant difference to how much interest you pay.

With Interest Only mortgages the amount of loan that is outstanding remains the same throughout your mortgage deal and therefore the amount of interest you pay is known at the beginning of each year, assuming interest rates don’t change.

However, this is not the case with repayment mortgages, also known as capital and interest mortgages. With this type of mortgage part of your monthly payment is used to reduce the amount of your loan outstanding. This means at the end of each year you will have less mortgage debt than at the start of the year. A number of years ago most lenders calculated interest annually. This meant that at the start of each year they looked at the amount of mortgage that you owed and based the interest that you would pay in the following year on that amount. They took no account of the amount of your mortgage that you paid off monthly during that year. At the end of the year they would look at the reduced amount of mortgage that you now had and start the process again.

In recent years a significant number of lenders have moved to calculating interest daily. This is more beneficial to the borrower because the amount of interest you pay takes account of the fact that your mortgage balance is reducing each month.

Let’s take a simple example of a repayment mortgage of £100,000 being repaid over 20 years with an interest rate of 5%. The monthly payment would be £659.96. Of this approximately £250 is for repayment of the loan. So after six months you would have paid roughly £1500 of your £100,000 mortgage back. So why should you have to pay interest for the second six months on a loan of £100,000 when your mortgage is now only £98,500? Well you don’t have to. If you take out a mortgage with a lender who calculates interest daily you will only ever pay interest on the actual amount of loan that you have outstanding.

The best way to make sure you get a mortgage with interest calculated daily is to use a mortgage search engine that allows you to look only at mortgages that have this feature. It’s not the only thing you should take account of – ultimately the true cost of the mortgage over the mortgage deal is what matters – but its worth looking out for.