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There are a number of ways in which a lender may calculate your monthly mortgage payments. This article provides some guidance on these methods and how you can determine how your payments will increase after a rate change.
This article provides some guidance on how mortgage lenders in the UK calculate your mortgage payments. There are no set rules defined by the Financial Services Authority (FSA ), however lenders must be accurate on the illustrations and mortgage offer documents they supply to you.
How interest is charged
Mortgage lenders use a number of different methods for charginginterest, these methods fall into one of three categories: -
- Daily interest charging.
- Monthly interest charging.
- Annual interest charging.
Annual interest charging
The most simplest of these is the annual interest chargingmethod, this is certainly the oldest method adopted by lenders. Interest is charged at the start of the year based on the mortgage balance figure. This interest amount is then divided through the 12 months of the year for each payment for an interest-only mortgage or combined with capital for each payment if a full repayment mortgage.
Interest-only calculation
Monthly payment = (balance x rate)/12
So with a balance of £100,000 and a rate of 6.5%: -
Monthly payment = (100,000 x 0.065)/12 Monthly payment = £541.67
Full repayment calculation
Monthly payment = [[rate x (balance x (1+rate)^term)]/(1-(1+rate)^term) ] / 12
so with a balance of £100,000 and a rate of 6.5%: -
Monthly payment = [[0.065 x (100000 x (1+0.065)^25)]/ (1-(1+0.065)^25) ] / 12
Monthly payment = £683.18
Monthly interest charging
With monthly interest charging, the annual interest rate is first divided by 12 to establish a monthly interest rate. This new monthly interest rate is then applied to the mortgage balance to calculate a monthly interest charge for each payment on an interest-only mortgage or combined with capital for each payment if a full repayment mortgage.
Interest-only calculation
Monthly payments = balance x (rate/12)
So with a balance of £100,000 and a rate of 6.5%: -
Monthly payments = 100000 x (0.065/12)
Monthly payments = £541.67
Full repayment calculation
Monthly pay rate (mrate) = rate/12
Monthly payment = [mrate x (balance x (1 + mrate)^(term x 12)]/[1-(1+mrate)^(term x 12)]
so with a balance of £100,000 and a rate of 6.5%: -
mrate = 0.065/12
Monthly payment = [0.0054 x (100000 x (1 + 0.0054)^300]/[1-(1+0.0054)^300]
Monthly payment = £675.21
As you can see there are benefits to having a monthly interest charged mortgage over an annually charged one if your mortgage is a full repayment mortgage as this example shows a saving of £8 per month.
Daily interest charging
Many mortgage lenders in the UK have now adopted daily interest charging methods, this method is far more complicated and many lenders have their own rules on how they calculate daily charges of interest. Taking one example of such a method we can see how much savings can be made when interest is charged daily instead of monthly or annually. In order to calculate the daily rate of interest we start with the annual interest rate and divide this through by 365.25 days (0.25 being the leap year). multiplying by the number of days in a given month. However you do not make mortgage payments every single day so these charges are rolled up and charged to you on a monthly basis. The advantage of interest being charged daily is when a borrower makes overpayments on their mortgage, lenders using the daily interest rate modal should reduce the balance immediately and the daily interest will reduce straight away thus providing an instant benefit. Daily interest charging is often used with flexible mortgages, offset mortgages and current account mortgages as these present huge benefits to the borrower.
Dealing with rate changes
Most of today's mortgages start of with a special offer rate for a period of time then the mortgage often reverts to the lenders standard variable rate. For example a 4.5% fixed for 2 years followed by the lenders standard variable rate currently 5.6%. How do you calculate what payments will be in 2 years time once the special rate period has expired? Simply put you just start over using the new balance, and remaining term. So based on an original loan amount of £100,000 and mortgage term of 25 years
Interest-only mortgage
First mortgage payment = 100000 x (0.045/12)
First mortgage payment = £375.00
then mortgage payments after the first 2 years will increase to:
First mortgage payment = 100000 x (0.045/12)
First mortgage payment = £375.00
Full repayment mortgage mrate = 0.045/12
First mortgage payment = [0.00375 x (100000 x (1 + 0.00375)^300]/[1-(1+0.00375)^300]
First mortgage payment = £555.83
In order to calculate the new mortgage payments after the first 2 years we must first calculate the new balance as capital will have been paid for 24 months: -
Future balance = Mthly pmnt x [(1-(1+mrate^(term x 12)))/mrate]-(-Initial balance x (1+mrate)^(term x 12)
Future balance = 555.83 x [(1-(1+0.00375^300))/0.00375]-(-100000 x (1+0.00375)^300
Future balance = £95467.67
Now we have a balance for 2 years in the future we can start over with a new balance and a 23 year term: -
Next mortgage payment =[0.00467 x (95467.67 x (1 + 0.00467)^276]/[1-(1+0.00467)^276]
Next mortgage payment = £615.91
Lenders will use a similar process to this when a variable rate changes during the term of the mortgage. The Lender will notify the borrower of a rate change, freeze the balance and remaining term, then start over with balance, new rate and remaining term.
Copyright (c) 2010 Steve Wentworth
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Steve Wentworth formed his firm Wentworth Financial Services in Nov 2007 having been in the industry since Nov 2002. If your require an Independent Mortgage Adviser click the link below: -
http://www.wentworthfs.co.uk/mortgages/mortgageadvice.aspx?KW=Mortgage%20Adviser%20Wirral
Read the original article in context at http://www.wentworthfs.co.uk/articles/mortgage-calculator-001.aspx
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