OK, in the last section we looked at how to repay the capital of your mortgage. Now we're going to look at the various ways to pay the interest. The first question to ask here is where do interest rates actually come from? Knowing the answer certainly won't make you sparkle at parties, but it is one of those things worth knowing anyway. The answer is that they are set by the Monetary Policy Committee (MPC) of the Bank of England. If the MPC thinks that the economy is doing rather too well, potentially setting off a nasty bout of inflation, then it will put up interest rates to slow things down. On the other hand, if the MPC thinks that the economy is going too slowly, and that inflation is not a real threat, then it will bring interest rates down to try to get things going again.

The MPC tries to make small adjustments well ahead of events (about eighteen months ahead), so as to avoid the need to make big adjustments later. If it fails to put up interest rates when it should, then the chances are that inflation will increase and, ultimately, rates will have to go much higher than they otherwise would in order to bring it back under control. It's a case of a stitch in time saving nine.

The base rate is effectively the rate of interest at which the Government borrows money in the very short term. The Government has the best credit rating there is, so if it is prepared to pay 6 per cent to borrow money, then everyone else will have to pay a bit more. After all, why would a bank take only 5 per cent from you and me if it can get 6 per cent from the Government? How much more everyone else has to pay depends on how good a risk they are. If you put your house up as security, then you're a pretty good risk and you should only have to pay slightly more than base rates, perhaps 0.5 per cent to 1 per cent more.

Watch out!

There are several enemies the Fool will encounter when he enters the mortgage scene - and they're usually the lender's best friends. Their best mate, though, is inertia. Once the lender's caught you and reeled you in, you are very unlikely to try and escape. Very few people change lenders over the term of their mortgage and, if they do, it's usually only when they move house. Lenders use this to their advantage and offer exciting introductory deals to entice you in. You might get a reduced rate of interest for two years for example, but afterwards, the rate rises to higher than it would have been otherwise. Even if you do try to switch to a better deal during the lock-in period, you'll often have to pay a redemption penalty to get out.

Different lenders calculate the interest you pay in different ways. In particular they use two sneaky tricks which means that the headline interest rate that they display is actually lower then the effective rate that you end up paying. This effective rate is known as the Annual Percentage Rate (APR). All lenders are required to display this rate in their adverts and it helps you compare rates from different lenders.

The first trick is to charge you interest on the amount outstanding at the beginning of the year and not to give you credit for any repayments of capital made during the year. Trick number two relates the calculation of the interest rate applied to your loan and the explanation is rather mathematical. However, you don't need to understand it. Just make sure that when you are comparing mortgages that you compare the amounts you pay over each month or the APRs rather than comparing the headline rates splattered over lenders' adverts.

Another thing to watch out for is being tied to the lender for house insurance. Lenders get commission from their chosen insurance company and you will undoubtedly be paying over the odds if you go for a lender who requires you to insure your property through them.

There are plenty of other inducements to persuade you to take out a mortgage. Some of the instant ones can include the offer of a lump sum in cash once the forms are signed (though I would hesitate to describe the cashback as a bribe!). The cashback can be useful if you haven't got any money to pay for furniture or legal fees or moving costs, but remember, unless you take the trouble to move, you'll have to pay for it later.

Most of the special deals are only offered for short periods of time - perhaps for only three to six months. So it's always worth scouring the money sections of the national newspapers or the 'Best Buy' sections of mortgage websites, to find out where the best window of opportunity lies at any particular time.

All this means that, before taking a mortgage, you need to decide what sort of person you are. If you are very diligent with your financial affairs, then you might want to go for the mortgage with the best deals to start with because you know that you'll make the effort to switch to something better at the appropriate moment.

If, on the other hand, you're the type of person whose finances are not so organised - and be honest with yourself! - then you need to go for a mortgage that won't get any worse over time. This might mean a "tracker" mortgage, or a fixed rate mortgage, or a variable rate mortgage with one of the few lenders whose variable rates are attractive (because they don't offer all the discount and cash-back mortgages which need to be subsidised by a high variable rate).

Anyway, with this in mind, let's have a quick look at the various options.

Variable-rate and tracking mortgages

This is the general rate of interest that lenders use. It's linked to the Bank of England's base rate and moves up and down in line with it, though it's usually about 2% higher than the base rate. So whenever Dermot Wotsisname announces on the News that the Bank of England has raised or cut interest rates by a quarter or half a percent, you'll know your mortgage is about to go or down up by a similar percentage.

In fact, a favourite trick by lenders is to introduce any increase with effect immediately and to delay any cuts by a month or two. As we said above, the variable rate is usually the most expensive option for the borrower because lenders often need to use it to make back the money they lose on things like discounts and cash back. Not all lenders offer these sweetened deals, so not all variable rates are bad, but it's worth comparing any variable rate with current base rates. If it's more than about 0.75% to 1% higher than the base rate, then you should have nothing to do with it.

Tracking mortgages are similar to variable rate deals, except that the interest rate automatically moves with base rates. They are therefore more transparent than variable rate deals and generally preferable. Just like variable rate deals, if the interest rate is more than 0.75% to 1% higher than current base rates, then you should have nothing to do with it.

Fixed-rate mortgages

This is exactly what it says. The rate of interest is fixed for a certain length of time - usually 1-5 years so you will know just how much you will need to find each month to pay the mortgage. Just as the interest rate on variable rate and tracking mortgages moves with the interest rate that the Government pays on its short-term borrowing, the interest rate on fixed rate mortgages moves in line with what the Government pays on its long-term borrowings. You can find out more about this in two articles here and here.

Effectively this means that the interest rate is set to take account of everyone's expectations about where interest rates are headed. So, on average you'll do no better, and no worse, with the cheapest fixed rate than with the cheapest tracking or variable rate (ignoring introductory offers). What fixed rate mortgages do give you, though, is some certainty. You know exactly what your monthly payments will be for the duration of the fixed period and this can help with your budgeting.

The final point to make about fixed rate mortgages is that the longer the period of your fixed rate, the more risky it becomes. This is because if it goes wrong for you and interest rates fall, it will be longer before your fixed period ends and you can move on to the lower rate. Generally speaking, fixed rate deals of more than five years are probably too risky for most people. There are plenty of people who took out ten-year fixed rate deals in the early 1990s (when interest rate expectations were much higher) who have been kicking themselves for a long time now.

Capped-rate mortgages

These ensure that there is a ceiling to the maximum interest rate you will pay over a given period of time. If your lender's variable rate climbs higher than the capped rate you will benefit because you just have to pay the capped rate. On the other hand, if it falls below the capped rate you'll just be paying what everyone else is paying. Capped rates generally last for a set period of time - usually between 1 and 5 years but we've recently seen the introduction of the first mortgage to be capped for 25 years. These are quite common in the United States but the concept is new to the UK.

Like fixed rates, a capped rate mortgage gives you a bit of certainty and helps you to plan ahead. The trouble with them is that they make it very hard to compare with other deals. Any benefit of capped rates over fixed rates relies on you correctly predicting that interest rate expectations are more likely to rise than to fall and, in the absence of a crystal ball, there's no real way of doing this. One way or another, because the lack transparency, there's a good chance that capped rate mortgages will end up costing you more than the cheapest tracking, variable and fixed rate mortgages.

Discount-rate mortgages

This is simply a percentage discount off the lender's variable rate. So your monthly payments will move up and down in accordance with the lender's normal rate but you'll be paying at a reduced rate over the relevant time period. These are quite good for first time buyers as it can give you a couple of years of breathing space. They're especially good if there's no lock-in period afterwards as you can simply re-mortgage with another lender when the discount period comes to an end. Often, though, you'll find you're locked in for another couple of years on the variable rate though. Even if you're not locked in, remember what we said above about inertia.

As an aside, you may have heard of the Government's new proposed CAT Standard Mortgage. Lenders who decide to offer these won't be allowed to charge extended redemption penalties once the term of your special fixed/discount/capped deal is up. They won't be able to insist that you take out a mortgage indemnity guarantee to protect them from you defaulting on the mortgage, nor will they be allowed to make you take out house insurance with their own, usually more expensive, insurer. Not surprisingly, lenders have reacted rather badly to the notion of not being able to make even more money out of their borrowers so they've been a bit backward in coming forward with suitable CAT standard products. Watch this space!

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