Matt McCorry's Blog Interest Rate Impact Upon Principal
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Matthew McCorry

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Interest Rate Impact Upon Principal

MortgageInterest

Matt McCorry, 3 months ago

Overview

Recently, I had to re-fix the mortgage on my house.  As with most people, the rate went up.  Fine, I was expecting that.  What confused me, was that despite the interest rate doubling, I was not paying the old monthly interest on top of my old payment.  Roughly speaking, my old payment was £1,400 a month, consisting of £1,000 principal, £400 interest.  I would have expected the new payment to be £1,000 + (2 * £400), but it was *only* £1,700. I noticed that the amount of principal paid per month dropped, allowing for the smaller monthly payment increase.

Example

Assume a nominal £100,000 mortgage over 25 years.  One will be fixed at 2% for the term, one will be fixed at 2% for 5 years, 4% for 5 years, and 2% again for the final 15 years. We will also compare against a decrease to 1% for years.

Type Payment Year 1-5 Payment Year 6-10 Payment Year 11-25 Total
Fixed 25 Year £424 £424 £424 £127,156
5 year increase £424 £508 £442 £135,480.00
5 year decrease £424 £385 £414 £123,060.00

Why?

At the end of the mortgage, the majority of the payment goes to principal, very little to interest, so there is more cash available at the end of the mortgage to pay down the principal, so in turn earlier in the mortgage, less needs to be paid down.  This explains why the amount of principal paid per month dropped when the rate when up. It must also work the opposite way too, where a time of lower interest rate would decrease the monthly payment due even when the rate goes back up.