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Take an Interest in Property: interest rates explained

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Interest rates have a huge impact on the economy, and on your own investments and debts. Our simple guide will take you through how interest rates will affect your mortgage.

How interest rates work

Interest rates determine the cost of borrowing money. The underlying figure you need to be aware of is the base rate, set by the Bank of England Monetary Policy Committee, which aims to maintain monetary stability. It sets interest rates to either encourage spending by lowering rates, making borrowing easier and saving less attractive, or to slow the economy down by raising them. Interest rates are currently at their lowest in UK history (0.5%) but have been as high as 17% (in 1979) so bear in mind that higher rates do occur.

How interest rates affect your mortgage

Your mortgage type has a direct effect on how much interest rates will affect you. The monthly payment on a repayment mortgage will be affected less than with an interest-only mortgage, but it will also depend on the type of mortgage you have. Its important that you keep an eye on different mortgage offers and changing interest rates as you may be better off switching to a new mortgage if the rates are significantly lower and, despite paying arrangement and penalty fees, you will be better off over time. However, by remortgaging on a mortgage of the same period you will just be deferring the date that you need to repay the lender, and whilst a fixed rate offers short term security, you can never be certain that rates will behave as predicted.

Fixed Rate Mortgages

Interest rate impact: None for the duration of your fixed period, but crucially, the rates available will be determined by projected interest rate changes. You can budget your outgoings accurately, and if interest rates do change significantly, you are safe from any enormous rises. However, you could be paying over the odds if interest rates fall further, and you tend to be locked into these deals for the duration of the fixed term - there are likely to be penalties for dropping out sooner to pursue a lower rate policy.

Bear in mind: These mortgages are fixed for certain period of time (usually between one and five years) so remember that your 'fixed' repayment is not guaranteed indefinitely, and you may need to shop around more often to keep your mortgage competitive. Make sure you know what happens to your mortgage when your fixed term ends; you may be in for a big shock if interest rates are much higher than your current fixed rate.

Tracker Mortgage

Interest rate impact: Direct. When interest rates are low, you will pay less each month. Depending on your deal, you may be able to pay extra each month while rates are low to pay off your overall amount more quickly. If interest rates rise, your monthly payments will go up. Even small interest rate changes can have a big impact on your monthly repayments.

Bear in mind: Mortgage lenders often offer attractive introductory tracker rates for a set period of time, which then revert to their standard variable rate (see below).

Variable Rate Mortgage

Interest rate impact: Generally direct, but lenders are free to set their variable rate independently of the Bank of England's base rate, though most usually follow its movements. Most fixed rate or tracker mortgages revert to the lender's variable rate after the initial offer period ends, so it pays to look into the longer-term rates your mortgage provider is offering so you don't get hit with high repayments further down the line.

Capped rate mortgage

Interest rate impact: Similar to variable rates, though with a little added safety by being capped at a certain fixed percentage allowing you to know your worst case scenario up front.

Bear in mind: Your interest rate may be slightly higher with this type of mortgage however, to allow for the cap.

Foreign currency mortgage

Most mortgage lenders require the mortgage to be in the currency of the dwelling's location, which are subject to local interest rates, so do your homework before investing in that dream holiday home.

There are many other aspects of mortgages to watch out for; penalties for early repayment or switching lender, high arrangement or legal fees and extended tie-ins linked to attractive initial offers being just a few. But the interest rates set by the Bank of England and your mortgage lender will have the greatest impact on both your monthly payments, and how quickly you can pay off your total debt. It pays to understand this area before you buy, to save yourself any nasty shocks later on.