Purchasing a house using a mortgage loan is one of the most significant financial investments one would have to make in life. Typically, the mortgage lender finances a specified percentage of the property’s buying price, on an agreement that you will repay over a given period with interest. The mortgage interest is arrived at by use of a given rate, which is determined by the lender. However, the interest you pay on a monthly basis may vary depending on the type of mortgage you choose. When applying for a mortgage and choosing a suitable lender, therefore, it is quite essential to know how the interest accrues every month. This post discusses how mortgage interest is calculated and it is worth noting you should never borrow above your means otherwise your property could end up in the hands of debt collectors uk.
Types of Mortgage Loans
Usually, mortgage lenders offer three types of loans depending on the type of interest accrued. These loan types include fixed-rate loans, adjustable rate loans and interest-only loans.
• Fixed-Rate Loans
With this type of loan, the interest rate remains constant throughout the mortgage term. Most mortgagors prefer fixed-rate mortgages because they are predictable. This is because one is aware of the amount of money they are expected to pay at the end of the month.
• Adjustable Rate Loans (ARM)
These loans come with an interest rate that changes based on an outlined index or specified conditions. For a given period of time, the initial interest of an ARM remains constant, after which the rate changes periodically.
• Interest-Only Loans
These are loans where the mortgagor pays interest within the first few years of the loan term. This type of mortgage is suitable for individuals with irregular incomes or affluent homeowners.
How to Calculate Mortgage Interest
1. For Fixed Rate Loans
While the interest and the principal amount may change periodically, the repayment amount does not change throughout the life of the mortgage. Typically, a fixed-rate mortgage will have a term ranging from 10 to 30 years.
To calculate a fixed-rate loan, here are some basic elements to take into account;
- Divide the rate of interest by the total number of payments in a year. If payments are made on a monthly basis, then you will divide the interest rate by 12.
- Multiply the value you get by the principal balance. In this case, the first principal balance is the value of the mortgage. This will give you the first month’s interest.
- To determine the value that you have paid off the mortgage principal, subtract the interest you calculated from the repayment amount.
- Subtract the value you get from the original principal to determine the outstanding (new) loan balance.
For example, if you intended to borrow a fixed-rate mortgage of £500,000 with an annual interest rate of 4.5% and lifespan of 30 years, then your estimated monthly repayment would be £2,533.43. (Since this calculation takes into account multiple factors, such as taxation and insurance, you might want to use a mortgage repayment calculator.) The 4.5% annual rate can be broken down into a monthly rate (by dividing it by 12 months), giving you a monthly interest rate of 0.375%.
Using this monthly interest, your first mortgage interest would be £1,875. Subtract £1,875 from £2,533.43 to find the amount of principal that you will have paid off in the first month (£2,533.43-£1,875= £658.43). At this point, the new principal amount (to be used in the next period) will be £499,341.57.
Note that as you continue with the consecutive monthly payment, the interest accrued will be less since the principal amount will have declined.
2. For Adjustable Rate Loans
Since the interest rate of an adjustable rate loan is not locked in, period payments will change throughout the mortgage term. However, there is a cap or limit that regulates the extent to which the interest may fluctuate and the frequency of fluctuation. To calculate the interest of an ARM loan, the following factors must be taken into account;
• Determine the number of remaining payments or months.
• Establish a new amortisation schedule for the remaining period.
• Use the new loan balance as the outstanding loan limit.
• Use the new interest rate.
For example, if you decide to borrow a £500,000 ARM loan with a current interest rate of 3.98% and 25-year lifespan, then the initial monthly repayment would be £2,634. If this rate increases with 0.5%, then your monthly repayments will shift to £2,773, which is an extra £139.
3. For Interest-Only Loans
With an interest-only loan, you do not have to clear the loan with each required payment. However, mortgagors can pay extra in different months to settle the debt as they wish. Calculating the interest of an interest-only mortgage is simple. Take the principal amount, multiply it by the interest rate and divide by 12 months.
This interest remains constant until;
• Additional payments are made above the required minimum monthly payment.
• The mortgage reaches a period when you are supposed to make amortising payments to clear the loan.
• There is a need for a balloon payment to clear the mortgage entirely.
More Information & Useful Resources