How Do Mortgage Interest Rates Work?

Any mortgage will have a regular interest rate that is charged to the amount owed.

The rate may be flexible or fixed. Generally, rates are determined by the deal offered by the lender at the time of application. The borrower would usually choose the rate and deal type which they believe to be most appropriate to their needs.

Normally, these deals have some sort of special inducement or offer to make them compare well with the competition. This is because the mortgage market can be phenomenally competitive.

These speacial deals will also have a specific time span attached. For example, an interest rate may be fixed at a set percentage for two, three or five years. Discounts offered to variable rates will usually work in the same way.

In the US, these flexible deals are known as 'ARMs'. This stands for Adjustable Rate Mortgage. In the UK, they would normally be referred to simply as a variable rate.

At the end of this initial term, whatever it may be, the interest rate will usually revert to the base rate or standard variable rate. This rate will track the interest rates set by the national government, for example by the Federal Reserve or Bank of England.

Interest charges are usually calculated by a lender on a daily basis. This enables them to be exact is an overpayment is made or a final redemption balance requested. However, it goes without saying that this is not how interest is paid.

Simply because months have differing numbers of days, lenders request a standard monthly payment. This payment will actually be the daily interest charge, multiplied by 365 days in the year and then divided by 12 (months). This will make it easier for borrowers to set their monthly budget.

Many lenders - and this is very common in America - set their monthly payments to borrowers with variable interest rate deals once per year. Again, this is to help borrowers with their monthly budget.

Should interest rates alter during the course of a year, the daily interest charge will be amended. But, the monthly payment of the borrower will not move. The total changes for the year will be made by the lender once.

Clearly, this can mean that if interest rates fall, borrowers will be overpaying slightly each month. It also means that should rates rise, borrowers will be underpaying. This can have the psychologically (very) damaging effect for a borrower of paying all payments in full and on time and still owing more money at the end of the year than at the start!