Annual mortgage interest – An interest free loan for the lender at what cost to you?

Julia Harris, mortgage analyst at moneyfacts.co.uk investigates: “If you have battled your way through the minefield of mortgage options, interest types, rates, fees and other terms and conditions currently available, there is one final piece to the jigsaw of which many borrowers may be blissfully unaware, but which could end up costing them thousands of pounds in additional interest charges. It is purely down to the way in which their mortgage interest is calculated.

“Generally speaking mortgage lenders will adopt one of three different frequency periods for charging interest, daily, monthly or annually. Assuming only one monthly mortgage repayment is made, then daily and monthly interest will equate to the same total charge. This is by far the fairest method, whereby any repayments made will automatically be deducted from the balance, thus only charging interest on the mortgage balance outstanding.

“However, should the provider only calculate interest on an annual basis, your monthly repayments will not be deducted from the balance for interest purposes. So for the full twelve months interest is charged on the mortgage balance owed at day one. Effectively the lender is holding your repayments until the end of the charging year, but will calculate the interest on an ongoing basis.

“The use of annual interest is more common than you may think. Moneyfacts.co.uk research has found that 20 lenders, that’s 1/6th of all lenders, use an annual interest calculation on some of their products or on their entire product range.

“Annual interest ultimately means that the lender will have an interest free loan from the borrower, and as a result the borrower will be faced with a larger interest bill.

“Take for example an average repayment mortgage of £130K over a 25 year term and assuming an interest rate of 5%. The difference between annual and daily interest would be an extra £8.68 per month. Over the term of the mortgage this equates to a whopping £2,604 extra interest paid.

“Put another way, repaying an extra £8.68 per month on a daily interest mortgage would knock six months off the repayment term. Another way of looking at it is that it adds the equivalent of 0.10% to your interest rate.

“If you are making overpayments to your mortgage, you would be well advised to check how your interest is calculated. If you find yourself being charged annually, and if your terms allow, why not put the extra monthly payments into a savings account, allowing you to earn interest, then apply it to your mortgage in one lump sum. Otherwise you are simply giving your lender extra money interest free for up to 12 months.

“Lenders are in business to make a profit, but if you see a rate that looks too good to be true, then there may well be a catch in the form of a large fee, annual interest or extended tie in. So make sure you know the full details before signing up, find a deal suited to your circumstances and review your mortgage regularly.”