How interest is calculated on your home loan

What is the interest charged on a home loan?

If you know even the smallest thing about home loans, you probably know there's an interest rate attached to them. This is what the lender charges you to borrow money from them.

When you make your mortgage repayments there are typically 2 parts to them: the principal and the interest. Each repayment goes towards paying back both the money you borrow (the principal) and the interest (charged by the lender).

Lenders calculate your interest charges daily or monthly, and it can surprise people to find out that the interest part of your repayments can add up to a huge chunk of money on top of your original loan amount.

In fact, if you borrowed $600,000 on a 30-year loan with an interest rate of 6.0%, you'd pay another $695,030 in interest on top of your loan amount. That's right – almost $1.3 million on your $600,000 loan.

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How is home loan interest calculated?

Interest on your home loan is usually calculated daily and then charged to you at the end of each month. But, you'll notice that your interest rate is charged per annum. Your bank will take the outstanding loan amount at the end of each business day, multiply it by the interest rate that applies to your loan, then divide that amount by 365 days (or 366 in a leap year).

What factors affect the amount of interest you pay?

• Reserve Bank cash rate. Home loan interest rates are generally based on the official cash rate set by the Reserve Bank of Australia 8 times a year.
• Home loan interest rate. Although partly determined by the RBA, you'll notice banks charge a higher rate and that's because they set their own rates for thier own reasons.
• The amount you borrow. Not always, but if you borrow a high amount or a high LVR you might end up with a higher interest rate.
• The outstanding loan amount. As you gradually pay off the money you borrow, you'll pay interest on a smaller loan amount and your interest payments will slowly reduce. The interest when you first start paying off a $600,000 loan will be much more than when you've paid off half the loan.
• The number of days in the month. Because most lenders calculate interest on home loans daily and then charge that interest to you each month, you could pay a smaller amount of interest in February (with 28 days in the month) than you do in March (with 31 days).
• Loan term. Paying your loan off over a shorter period will mean your monthly repayments will be much higher, but you'll pay off the loan faster and pay much less in interest!
• Repayment frequency. Most lenders allow you to make repayments weekly, fortnightly or monthly. The more frequently you make repayments, the less interest you will pay. Use our bi-monthly calculator to see how your interest payments will vary depending on your repayment frequency.
• Offset accounts. Any money in your offset account will be taken off the loan value your lender is charging interest against. If you have a $600,000 loan but you have $100,000 saved in your offset, the lender will only charge interest on $500,000. Your repayments will stay the same, but because you're paying less interest you're making more repayments towards your loan principal. That means you could pay off the loan faster.

Principal and interest vs interest-only

Ok so remember when we said your mortgage repayments will pay off a bit of the principal loan amount and a bit of the interest... that's not always the case. Although principal and interest repayments are the most common way to pay off a home loan, you could choose an interest-only home loan instead. This is where you only repay the interest and, yes, not pay down the loan.

Interest only loans are designed to allow you to make interest-only repayments for a certain period, for example if you're building a new home or if you're a property investor with an investment mortgage. This allows you to reduce your regular repayment amount.

If you're struggling to repay your home loan, your lender may be able to move you onto an interest only loan for a short period. Your repayments will reduce and give you a bit of breathing space, but remember that you are not reducing your loan amount. This means that when you begin repaying principal and interest again you may have even higher repayments so that you can still repay in the loan term.

How to save interest on your home loan

Now that you know a bit more about how interest is calculated, let's look at the ways you can pay less of it.

• Get the best rate. Shopping around for a better interest rate can save you thousands of dollars. You may want to even consider refinancing with your current lender or switching to a new lender.
• Look for an offset account. Home loans with offset accounts allow you to reduce the principal amount that you need to pay interest on by "offsetting" the loan principal with your savings. It's a powerful and free way to super-charge your mortgage repayments.
• Make frequent repayments. The more frequently you make regular loan repayments, the less interest you will have to pay as interest is calculated daily. Even paying weekly or fortnightly instead of a monthly can help you make headway.
• Make extra repayments. The ability to make extra repayments without penalty can work strongly in your favour. Extra repayments off the principal loan amount now mean less interest you pay over the life of the loan.
• Choose a shorter loan term. The longer you take to pay off your loan, the more interest you will end up paying. Remember, banks calculate interest on your loan amount daily. Choosing a 25- instead of a 30-year loan term can make a big difference to the amount of interest you pay overall.

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Frequently asked questions about how interest is calculated on a home loan

• What is a good interest rate on a home loan?

  The answer to this question can change, as banks and lenders will change their interest rates depending on some of the factors mentioned above.

  At the moment, fixed interest rates are slightly better than variable interest rates. But this would mean you're locked into that rate for a set period, and if rates drop over that time you won't benefit from lower rates. At the same time, if rates increase you would be locked into a better rate. The lowest fixed rate on the market right now is 5.99%.

  The lowest variable rate on the market right now is 5.69%.

• What is 6% on a $500,000 home loan?

  The total interest payable on a 30-year $500,000 home loan would be $579,191 - assuming the interest rate never changed from 6% (which is very unlikely).

  The initial monthly interest charge would be around $2,465.75, but this would decrease over time.

  You could work this out with the following formula:

  (Remaining loan value (minus any offset) x interest rate) ÷ days in year = daily interest charge

  (500,000 x 0.06) ÷ 365 = $82.19

  $82.19 x 30 (days) = $2,465.75

To make sure you get accurate and helpful information, this guide has been edited by Joselle Delos Reyes as part of our fact-checking process.

Written by

Sarah Megginson

Money expert + media spokesperson

Sarah is the author of How to Raise Rich Kids. With over 20 years of experience in property, finance and investment journalism, she is a trusted expert whose insights regularly appear across television, radio and print media, including Sunrise, Channel 7 News, Bloomberg and Yahoo! Finance. She has previously served as managing editor for Your Investment Property and Australian Broker. Her expert advice has been shared in the media over 4,000 times. Sarah holds a Bachelor’s degree in Communications and a Tier 1 Generic Knowledge certification, which complies with ASIC standards. See full bio

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Sarah has written 242 Finder guides across topics including:

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