How Mortgages Work

What a mortgage actually is

A mortgage is a secured loan: the lender advances you money now; in return, you promise to repay it with interest over many years, and the property itself is held as collateral. This is why mortgages can be offered at much lower interest rates than unsecured personal loans — the lender’s risk is dramatically reduced by having the asset to fall back on.

The legal mechanism varies by country. In England and Wales, you own the property from day one (via “legal charge”). In Scotland, the system is similar but the terminology differs. In the US, the process involves promissory notes and deeds of trust.

Loan-to-value (LTV): the number lenders care about most

LTV is the mortgage amount divided by the property value, expressed as a percentage.

• Property value: £300,000
• Deposit: £30,000 (10%)
• Mortgage: £270,000
• LTV = 90%

A higher LTV means more risk for the lender (less equity buffer if prices fall), so they charge higher interest rates. Lenders typically offer their best rates at 60% LTV; rates rise in tiers (75%, 80%, 85%, 90%, 95%).

Negative equity occurs when your LTV exceeds 100% — i.e., the mortgage balance exceeds the property value. This happened to millions during the 2008 financial crisis. You can’t sell or remortgage (without penalty) in negative equity.

How amortisation works

Each monthly payment you make has two components: interest and capital repayment.

In month 1, your entire £270,000 balance is attracting interest. If the rate is 4.5% annual, the monthly interest is approximately:

£270,000 × (4.5% ÷ 12) = £1,012.50

On a 25-year term at that rate the monthly payment is £1,501. So in month 1 only £488 goes toward reducing the loan — the remaining £1,012.50 is interest. (The calculator further down this page runs exactly this example, so you can change the numbers and watch the split move.)

By month 300 (final month), you owe only a small balance — say £1,494 — so the interest portion is tiny and almost all of your payment pays off the loan.

This is amortisation: the gradual shifting of the payment from mostly interest to mostly capital over the loan term. It’s why early overpayments have a disproportionately large impact — they reduce the balance that’s accruing interest for decades.

Fixed-rate vs variable-rate mortgages

Fixed rate:

• Your interest rate is locked for a deal period, typically 2, 5, or 10 years
• Predictable monthly payments regardless of Bank of England base rate changes
• Lender charges an early repayment charge (ERC) if you leave during the deal period
• At the end, you roll onto the lender’s standard variable rate (SVR) — usually expensive

Tracker mortgage:

• Follows the Bank of England base rate plus a set margin (e.g., “Base rate + 1.5%”)
• Payments change when the base rate moves
• Usually no early repayment charge → more flexibility

Standard Variable Rate (SVR):

• The lender’s default rate after your deal ends
• Typically 2–4% above base rate — usually the worst rate available
• No exit penalty — nothing stands in the way of switching

The cost of doing nothing: an SVR example

Suppose you have a £250,000 mortgage. At 5% (your fixed rate), you pay £1,461/month. When the deal ends, your lender’s SVR is 8%.

• At 5%: £1,461/month
• At 8%: £1,929/month
• Difference: £468/month = £5,616/year

Remortgaging to a new 5% deal takes a few hours of admin. The saving is substantial.

The mental model: a mortgage is renting money to buy a house

Think of a mortgage as renting money from a bank. Your monthly interest payment is the “rent” on the capital. As you pay off the loan (capital), you’re buying more of the money back — so there’s less to rent, and your interest payments gradually shrink.

The lender is simultaneously a landlord (of money) and has a safety net (your property). That’s why they offer such large sums over such long periods.

Common misconceptions

“A bigger deposit always saves you more money.” Not necessarily. You have to weigh the interest saving against the opportunity cost of tying up capital (that money could be invested). LTV thresholds matter though — crossing from 90% to 85% LTV usually unlocks a meaningfully better rate.

“Overpaying your mortgage is always the right move.” It depends on your mortgage rate versus the return you get elsewhere, and the comparison is not symmetrical. Paying down a 4% mortgage is a guaranteed 4% saved; an investment returning more than that is a forecast, not a guarantee, and can lose money. Overpaying also reduces flexibility, because the money is hard to get back. Which of those matters more depends on circumstances this article cannot see.

“A longer term means you pay more overall.” True that you pay more interest over time. But a longer term gives lower monthly payments, which can be the difference between affording a home and not. You can always overpay when you have spare cash.

“The lowest interest rate is the best deal.” Not if it comes with high arrangement fees. A 3.9% rate with a £2,000 arrangement fee may cost more than a 4.1% rate with no fee, depending on the deal length and loan size. Always compare the APRC (Annual Percentage Rate of Charge).