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Personal Finance: Interest Rates

The overall goal of the TransferGo blog is simple; the more financial information you have the better decisions you are able to make.  That is the reason we publish the articles which are found in our Personal Finance section.  We recently wrote about Annual Percentage Rates (APR) and how they affect you in day-to-day life.

One of the more complex areas of borrowing most people will encounter happens when applying for a mortgage.  While mortgages are stated in APR just like a credit card or car loan, the various methods of calculating the loan’s interest rate can be confusing.  When you are looking for a mortgage loan, one of the best ways to ensure that you do not experience a big surprise in the future is to understand the types of loans available and the advantages and disadvantages they offer.

Basically there are two types of loans: fixed rate and variable rate. With a fixed rate loan your interest rate will not change over the entire life of the loan.  The interest rate for variable rate loans can change, sometimes drastically, during the life of the loan based on a number of criteria.  Variable rate loans are offered in number of interest rate calculation methods.

Fixed Rate Loans

Fixed rated loans are the easiest to understand and are the easiest to work into your budget. The advertised rate will remain the same for the life of the loan. The interest rate you will be charged is based on a number of factors including the current market trends and your credit profile.

Advantages

The rate stays the same for the life of the loan.
You are protected from rising interest rates.

Disadvantages

The initial interest rate will likely be higher than that available for variable rate loans.
You do not benefit when interest rates fall.

Many mortgage holders with fixed rate loans will look for a new mortgage if interest rates drop to the degree that obtaining a new loan makes sense. If you want to be able to take advantage of favourable market conditions, read your loan documents to make sure there are no fees for paying off your loan early.

Variable Rate Loans

As we mentioned there are several types of fixed rate loans. A good rule of thumb is to make sure that you have enough savings or income to be able to make your payment if your loan payment amount increases dramatically.  The failure to be able to make payments after a low introductory rate on a variable rate loan when the interest rate increased was one of the main contributors to the recent US financial crisis.

Standard variable rate mortgages

These are the most common type of variable rate mortgages and are referred to as SVR loans. Your interest rate can go up or down at any time based on the base rate, which is set by the Bank of England. The exact method of calculating the rate will be contained in your loan documents.

Advantages

Generally you can make additional principal payments at any time.
You can move to a better rate mortgage at any time.
You reap the benefits when Bank of England rates fall.

Disadvantages

Your rate can change at any time during the life of the loan.
Higher interest rates can result in substantially higher monthly payments.
Loan payments are more difficult to budget.
You are not protected from rising interest rates.

Discount loans

The loans typically offer a discount over the SVR for a fixed period of time.  When comparing discount rates it is important to shop around.  The SVR can differ by a great deal from lender to lender.  A 2% discount can result in a lower interest rate than a 2.5% discount depending on the lender’s SVR.

Advantages

The loan is initially very inexpensive. This keeps your monthly payment lower. This may give you the opportunity to make additional principal payments which will save you money offer the long terms.
You are able to benefit from falling interest rates.

Disadvantages

Typically the lender can raise the SVR at any time. This can make it difficult to budget.
If the Bank of England base rate moves higher, your discount rate is likely to rise as well.

Just as with fixed rate loans make sure there is no penalty if you wish to move your loan to another lender.

Tracker loans

Tracker loans are fairly simple. The interest rate changes based on the changes of another interest rate, typically the one set by Bank of England. Your rate will rise or fall anytime the reference rate changes. During times of increased financial activity, both good and bad, your interest rate and therefore your monthly payment amount can change many times while you have the loan.

Otherwise the advantages are the same as a SRV mortgage.

Capped rate loans

The interest rates on these loans typically vary based on the same criteria of a SVR loan. The only difference is that the interested rate cannot rise above a specified rate.

Advantages

You reap the benefits of falling rates.
You limit your risk as the rate can never increase above the cap. One budgeting tip to use when considering a capped rate loan is to calculate the monthly payment at the highest possible interest rate. If making this payment would create a major hardship, it would be better to find a different loan.

Disadvantages

Typically these loans have a slightly higher introductory rate than other variable rate loans.
The cap can be set at a fairly high level.
The rate can change at basically any time and increases may not be tied to a change in Bank of England rates, and could rise for reasons such as a late or missing payment.

The main point to remember for all loans is to read the loan documents very carefully. Make sure that you are aware of any potential fees and conditions. Often attractive interest rates will be offered with conditions that will more than offset the benefits of a low interest rate.

2016-08-19

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