Types of Interest Calculation

Types of Interest Calculation

This section for types of interest calculation explains all the different types of interest rate calculations and how they affect you.

It explores some pitfalls to watch out for with charges and penalties.

If you are looking for actual interest rates and schemes available today  - then visit the mortgage enquiry page.

1. Daily Interest Method

You should always check what interest accounting calculation basis your mortgage interest payments are worked on.

Daily Interest calculations means exactly what it sounds like.

Daily Interest Method, the interest rate payment is set at the prevalent rate and debited to your account each day on a pro-rata basis.

The interest that you owe is debited to your mortgage account and you owe this fraction of interest each day.

This daily interest method may not be good for you if you wish to have known repayments throughout the year.  It may also not be good for you if interest rates increase through the year.

However, unlike Annual interest or monthly interest, as you move through the month, if you are on a repayment mortgage, the capital debt that you owe is reduced on the day that you make the payment and therefore, the interest that is charged the next day may reduce.

The system of daily interest method quite simply rewards early payers.  The sooner you make repayments, the sooner you have repaid the daily interest due and the debt that you owe is reduced ready for the next day's interest rate fraction calculation.

2.  Monthly Interest Method

You should always check what interest accounting calculation basis your mortgage interest payments are worked on.

Monthly Interest calculations, sometimes known as Monthly Rest schemes, means exactly what it sounds like.

Monthly interest method, the interest rate payment is set at the prevalent rate and debited to your account each month.

The interest that you owe is debited to your mortgage account and you pay this interest each month.

This monthly interest method may not be good for you if you wish to have known repayments throughout the year.  It may also not be good for you if interest rates increase through the year.

However, unlike Annual interest, as you move through the year, if you are on a repayment mortgage, the capital debt that you owe is gradually reducing and therefore, the interest that is charged each month may reduce.

3.  Annual Interest Method

You should always check what interest accounting calculation basis your mortgage interest payments are worked on.

Annual Interest calculations, sometimes known as Annual Review schemes, means exactly what it sounds like.

The interest rate payment is set at the annual review date and whether interest rates go up or down, the rate that you pay remains fixed until the next annual review.

The yearly interest that you owe is debited to your mortgage account at the start of the year in full and then you gradually repay this interest over the year.

This can be good for you if you wish to have known repayments throughout the year.  It can also be good if interest rates increase through the year.

However, if interest rates fall through the year, you will pay more than if your mortgage were arranged on a different basis.

Also, the annual interest method, one distinct disadvantage is that the interest is charged on the whole amount that you owe at the start of the year and takes no account of any reduction in the capital that you owe, or repay, over the coming year.  This is where monthly and daily interest calculations have an advantage.

4.  Mortgage Penalties, Charges

There are many types of Mortgage Penalties, Charges that you should be aware of when dealing with your mortgage.  You should check with your lender or read the small print of any potential lenders documentation.

Deeds release charge

Many lenders make mortgage penalties charges to release the title deeds of your property when you are selling it.  Be aware of this charge when you are budgeting for selling a property.

Redemption penalties

Check the small print as many lenders impose financial penalties for repaying your mortgage in full or in part early.  This does not matter whether you are buying your home outright or selling the home, repaying the mortgage or re-mortgaging.  Ask for a redemption quotation.

Cash back penalties

If you had a cash back mortgage you may have to refund all or some of this amount if you buy your home outright or sell the home, repay the mortgage or re-mortgage.  The figure should be included in any redemption quotation you request.

Annual and monthly interest basis

Be aware that if you have an annual or monthly interest accounting basis, you may have to pay the full interest due even if you will not be on a mortgage with a particular provider for the remainder of the term.

Buildings and contents insurance charge

If you find that you can obtain cheaper buildings insurance from someone other than your mortgage lender, which is extremely common, the lender may charge an 'administration' fee to allow you to insure elsewhere.  This is normally in the region of £25 to £50.

5.  Offset Mortgage

Flexible Mortgages - Stop/ Start and Offsetting Savings Against Interest Due On A Mortgage

With the trend for interest rates being lower at the present time than in years gone by, it is often tempting to go for that larger mortgage as you can borrow cheaply.  Likewise, the interest rates received on your savings are also not going to be that good.  We posed the question to our expert on how people could make their money work harder for them as well as saving money on mortgage payments.

The recent rise in the availability of new style flexible offset mortgage and savings linked accounts means that by planning carefully many people can save huge amounts on their offset mortgage or access overpayments at any time. 

This may have the effect of reducing the term of the offset mortgage and higher equivalent rates of return from savings accounts in low risk cash deposit based savings accounts. 

For example:  A client obtains a £100,000 mortgage over 25 years at a rate of 4.85% pa.  The monthly payments on a repayment mortgage basis are £576 per month.  However, the clients also have additional savings of some £47,000 in cash deposit accounts. 

The clients consider a offset mortgage and savings linked account with a major well known bank.  These special accounts work when your savings are invested with the same bank are offset against the amount that you have on your mortgage.  In simple terms these clients have opened two 'jam jars'.

How do the 'jam jars' work?

Jam jar 1 - The mortgage

The clients have a mortgage of £100,000 that will be rapid over 25 years.  Monthly mortgage payment of £576 per month.

Jam jar 2 -  The savings account

£47,000 is invested in a deposit account that receives no interest.  Yes, that is right, no interest.

Offsetting saves money

The amount owed in jam jar 1 is offset by the amount in savings in jam jar 2.  This means that the clients are only really in debt by £53,000.  This means that the amount really due on their offset mortgage is just £305 per month.  However, they actually still pay £576 per month.  The extra amount that they are paying is technically reducing the mortgage amount and therefore the term of the offset mortgage.

Access to savings

If the clients wish to take out some or all of their savings at any time they can.  They have complete access to all their savings accounts at any time.  Their mortgage payments remain the same it is just that less will be allocated to their savings pot to reduce the term of their offset mortgage.  This is because they technically owe more to the bank as the offset mortgage interest element will increase the less they have on deposit in savings.

The effect - return on 8.08% and saving £103,680.

As the above clients are higher rate tax payers, the equivalent rate of saving by not paying interest on their mortgage is 8.08% pa gross.  Where do you get a secure interest return like that these days?  For basic rate tax payers it is an equivalent rate of 6.21% pa. 

By overpaying on their offset mortgage, because they have offset their savings against it, these clients will reduce the length of their mortgage by a staggering 15 years to just 10 years!  That is a saving in monthly mortgage payments of 15 years at £576 per month i.e.  £103,680 and that is if interest rates remain unchanged, if interest rates go up it could mean even greater savings.

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