Question about mortgage interest vs. savings interest

DJ_Mike

First time poster, long time reader. I'm a First Time Buyer about to get my mortgage in place (for £187,495 at 5.84% fixed for 4 years). I've been doing a lot of ground work to see how many finances are going to pan out, but one thing struck me about the advice I read on the boards, and I wanted to see if this makes sense or if I've got something muddled.

It comes down to this - people here talk about savings rates vs. mortgage rates, and that if your savings rate (after tax) is less than your mortgage rate, then you should be paying off your mortgage instead.

However, the overriding problem with mortgage rates versus interest rates is that they're expressed differently.

My mortgage provider gives me a rate of 5.84%. But as far as I can tell, from the figures my broker gave me, they work out interest by doing 5.84 / 12 months, then applying that EACH month to the remaining balance - in other words, if (by some amazing weirdness) I didn't pay a single thing towards my debt, an interest of ~0.487% would be added to my account each month - meaning after a year my mortgage debt has gone up, NOT by 5.84%, but in fact just a tiny bit less than 6%, because the interest has been compounded each month.

Yet savings rates are always quoted as AER - Alliance & Leicester's Online Saver Issue 5 quotes a rate of 3.15% AER. To my understanding, this means that, before tax, you stand to gain 3.15% of your savings in interest after one year.

NOT 3.15 / 12, compounded monthly, or even 3.15 / 365, compounded daily - but simply 3.15%.

So my confusion is this - when people talk about comparing mortgages and savings, they always seem to compare interest rates directly, as if a mortgage rate is what the mortgage would be if allowed to sit, unpaid, for an entire year - is this really the case, or are banks truly charging what I think they're charging?

My lender tells me they work out interest daily - are they doing 5.84% / 365, or are they doing 5.84% ^ (1/365)? (The latter is how you obtain a de-compounded interest rate)

Sorry for the long post! But it seems to me if people are going to compare their mortgages and their savings, they need to be using the true AER of the mortgage, not just the bank-quoted rate.

Cheers,

M;.

Thrugelmir

DJ_Mike wrote: »

First time poster, long time reader. I'm a First Time Buyer about to get my mortgage in place (for £187,495 at 5.84% fixed for 4 years). I've been doing a lot of ground work to see how many finances are going to pan out, but one thing struck me about the advice I read on the boards, and I wanted to see if this makes sense or if I've got something muddled.

It comes down to this - people here talk about savings rates vs. mortgage rates, and that if your savings rate (after tax) is less than your mortgage rate, then you should be paying off your mortgage instead.

However, the overriding problem with mortgage rates versus interest rates is that they're expressed differently.

My mortgage provider gives me a rate of 5.84%. But as far as I can tell, from the figures my broker gave me, they work out interest by doing 5.84 / 12 months, then applying that EACH month to the remaining balance - in other words, if (by some amazing weirdness) I didn't pay a single thing towards my debt, an interest of ~0.487% would be added to my account each month - meaning after a year my mortgage debt has gone up, NOT by 5.84%, but in fact just a tiny bit less than 6%, because the interest has been compounded each month.

Yet savings rates are always quoted as AER - Alliance & Leicester's Online Saver Issue 5 quotes a rate of 3.15% AER. To my understanding, this means that, before tax, you stand to gain 3.15% of your savings in interest after one year.

NOT 3.15 / 12, compounded monthly, or even 3.15 / 365, compounded daily - but simply 3.15%.

So my confusion is this - when people talk about comparing mortgages and savings, they always seem to compare interest rates directly, as if a mortgage rate is what the mortgage would be if allowed to sit, unpaid, for an entire year - is this really the case, or are banks truly charging what I think they're charging?

My lender tells me they work out interest daily - are they doing 5.84% / 365, or are they doing 5.84% ^ (1/365)? (The latter is how you obtain a de-compounded interest rate)

Sorry for the long post! But it seems to me if people are going to compare their mortgages and their savings, they need to be using the true AER of the mortgage, not just the bank-quoted rate.

Cheers,

M;.

Yes you are correct.

Comparison of base interest rate does not reflect true rate.

InMyDreams

DJ_Mike wrote: »

My lender tells me they work out interest daily - are they doing 5.84% / 365, or are they doing 5.84% ^ (1/365)? (The latter is how you obtain a de-compounded interest rate)

Be careful because there isn't any borrowing or saving interest rate that compounds daily. Calculating daily is different to compounding daily. It won't be compounded until it's actually applied.

You are correct that it's hard to compare exactly because you have to take into account compounding, but it's close enough to be a good rule of thumb. The savings AER will indeed have to be very slightly higher than the mortgage rate to break even, but it's only by a small amount; a tiny fraction of a percent (as you discovered).

And actually your mortgage interest won't be compounded because you should be paying it off each month before it has a chance to! So the lender won't be worrying about 'decompounding' it.

Edit: as for how they work it out, I know that mine does the rate /365 and my interest is different depending on how many days there have been in the month, but I don't know that all do.

DJ_Mike

Indeed, that's one area I've probably muddled slightly, so thanks for the clarification.

When I spoke to Abbey, they told me they calculate interest daily - which means if I overpay (as I intend to), I should be paying in as early as possible, as the interest for each day I leave it will be 1/30th (or however many days there are in the month) of the monthly rate, multiplied against the outstanding balance of the loan, with the remaining days of the month being calculated as the same rate but multiplied against the newly-reduced outstanding balance of the loan.

So, for example, if Abbey take my regular payment on the last day of August (and assuming that's when they add the interest onto the loan), leaving a loan balance of £187,000, and I leave it till day 11 of September to overpay by £200, the interest they calculate for the end of September would be:

10/30 * (5.85% / 12) * £180,000
+
20/30 * (5.85% / 12) * £179,800

I assume the working above is reasonably correct.

But back to the main point - yes, you are correct that the difference between 5.84% and 6% is marginal, and yes, you won't be compounding the interest on a mortgage, because you're paying it off. However, my point is some of the literature on this website is slightly miscalibrated - you cannot directly compare between a mortgage rate and a savings account (AER) rate, because the equivalent monthly rate is worked out slightly differently - mortgages you divide by 12, savings you do (1 + AER/100) ^(1/12).

I just wanted to see if any financial experts concurred!

InMyDreams wrote: »

Be careful because there isn't any borrowing or saving interest rate that compounds daily. Calculating daily is different to compounding daily. It won't be compounded until it's actually applied.

You are correct that it's hard to compare exactly because you have to take into account compounding, but it's close enough to be a good rule of thumb. The savings AER will indeed have to be very slightly higher than the mortgage rate to break even, but it's only by a small amount; a tiny fraction of a percent (as you discovered).

And actually your mortgage interest won't be compounded because you should be paying it off each month before it has a chance to! So the lender won't be worrying about 'decompounding' it.

Edit: as for how they work it out, I know that mine does the rate /365 and my interest is different depending on how many days there have been in the month, but I don't know that all do.