![]() ![]() ![]() We’ve been talking about fixed rates so far, where the interest rate doesn’t change. Imagine what would happen if it were a £400,000 mortgage over 25 years! (Hint: it’s not pretty) Tricky, right? This is also the reason interest rates are so important: if you had a 5% interest rate in the above example, you’d pay almost £1,000 more in interest. Notice how this is the exact size of your payment-that’s what makes the formula useful. Year five (finally!), you make the final payment: £2,079.98 plus 2% interest sums up to a neat £2,121.58.This time, you pay interest of 2% on £6,118.40: this comes to £122.37. Year three, you make the same payment of £2,212.58.You’ll still make a payment of £2,121.58, but you’ll pay less interest this time. The second year, you owe the bank less (£8,078.42).(The principal is the amount you borrowed originally) Why is the difference between interest and principal important? Interest goes straight to the bank, but you subtract the principal from the amount you owe next year: £10,000-£1,951.58=£8,078.42. You’re paying 2% interest, so £200 of that payment is interest, the other £1,951.58 is principal. The first year, you owe the bank £10,000.You borrow £10,000 at 2% interest for five years, with yearly payments of £2,121.58 (You can use a calculator to check this.Mortgages in the UK use compound interest, so the math goes like this: However, if you borrow with compound interest, we have to calculate the interest every time you make a payment. If you borrow £10,000 for 10 years at 2% simple interest, you’ll pay £200 in interest each year: that's quite simple. The word “compound” makes things more difficult for us. There’s an old story that Albert Einstein called compound interest the “most powerful force in the universe.” While we’re not sure if it’s worthy of that much praise, it is quite powerful. Mortgage interest is basically the fee the bank charges you to borrow money. Banks need to make money off the money they lend, so they charge interest on a loan. Unfortunately for us, they do-quite a bit. It would be easy to figure out a mortgage payment if the numbers didn’t change over time. ![]()
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