When shopping around for the best mortgage deal, you already know that it is worth taking time to find the lowest rate of interest. But with some types of home loan, the way that the interest is calculated can also make a big difference to how much you pay over the term of your mortgage.
Modern mortgages products feature monthly or daily interest calculation as a cost-cutting selling point. But how much difference does it make if your interest is calculated annually or more frequently? The answer for interest-only mortgage borrowers is very little as the sum on which the interest is being paid is not decreasing. But for repayment mortgages, you may benefit more.
Annual, monthly or daily
When the mortgage interest rates on your loan is calculated on an annual basis, the lender will recalculate the interest they charge on the loan for the whole of the next year on the basis of the balance outstanding at the end of the previous year. This means that each monthly payment you make simply sits on your account and is not applied to reduce your mortgage debt until the end of the year. Some lenders calculate interest on a monthly basis. This means that if you make a payment on the first day of the month and the interest is recalculated on the last day of the month, you don't receive any benefit from that payment for 30 days. Interest calculated on a daily basis means that your payments have an immediate effect on the interest charged.
If you have a flexible mortgage then lump sum overpayments - if permitted - may increase the advantages of daily or monthly interest calculations. Any overpayment that you make has an immediate effect on the outstanding balance of your debt. The knock-on effect of this is that you immediately start benefiting from the savings on the interest that is charged on the loan capital, as there is a smaller loan to charge interest on. Remember that the reverse is true if you underpay or pay late. With a monthly or yearly interest calculation, you will not suffer from additional interest as long as you catch up before interest is recalculated. When it is calculated daily, you immediately start falling behind schedule in terms of reducing your outstanding capital.
The best time to pay in your lump sum is usually at the end of the year just before the annual interest rate review. Check with your lender to time it correctly and hold the cash in a high interest account in the meantime.
Mortgage experts say that interest calculated on an annual basis can make a mortgage 0.35% more expensive than one where the interest is calculated on a daily basis. However, the difference that monthly or daily interest will make to your monthly payments may only be small - a 25-year £100,000 repayment loan at 5% would cost £591 per month on annual calculations and £585 per month if interest was calculated daily.
Annual review
If your mortgage lenders carries out an annual review of the interest you pay then you could be in for some bad news in 2005. Under annual interest review rules, lenders are allowed to recoup any shortfall in interest charged in one year in the next. Mortgage broker Charcol predict the one million borrowers whose mortgage companies review interest annually will see a sharp jump in their mortgage payments following the base rate increases during 2004. For a typical mortgage of £100,000, those on annual review could find their monthly interest payments rise by £83, equating to £1,000 over a year, or even more if they are unlucky enough to be with one of the many lenders who have increased their interest rates by more than bank base rate.
'There are still many borrowers in the UK who have their mortgage structured on an annual review basis,' explains Charcol's Ray Boulger. 'This means any interest rate changes over the course of the year are amalgamated and applied to the mortgage at the start of each New Year. As payments will have been calculated on a lower interest rate at the start of 2004, borrowers on annual review will have a shortfall to make up next year. With base rate increasing by 1% during 2004 borrowers on annual review will see a significant increase in their monthly payment next year.' he adds.
Charcol estimates that many of these borrowers will be paying their lender's Standard Variable Rate (SVR), which means there is a good chance for many to mitigate the rises they will suffer.The difference between most lender's SVRs and current market-leading deals is around 2%, and so it would be easy for borrowers to not only avoid an increase in payments but to actually reduce what they are paying, despite their current payments being based on last year's interest rates.
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