How is interest calculated on a home loan?
Learning how interest is calculated helps you understand how mortgage repayments work and how you can reduce them.
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There are two parts to a mortgage repayment: paying back the money you borrow (the principal) and the interest charged by the lender. This interest adds up to a huge chunk of money on top of your loan.
From the Reserve Bank’s cash rate to the amount you borrow, there are several factors that affect the amount of your interest repayments. Let’s take a closer look at how home loan interest is calculated.
What factors affect the amount of interest you pay?
The following factors will affect the amount of your interest repayments:
- The home loan interest rate. This is the rate at which the bank charges you interest on the loan, such as 5% p.a. Some loans feature a reduced interest rate for an introductory period, which then reverts to the standard rate.
- The Reserve Bank Official Cash Rate. The interest rate on your loan is based on the official cash rate set by the Reserve Bank of Australia on the first Tuesday of each month (except January). The official cost of borrowing can prompt lenders to charge a higher or lower amount of interest.
- The amount you borrow. The bigger the sum you borrow from your bank, the more interest you will need to repay. For example, 5% of $1 million will always be a larger amount than 5% of $500,000.
- The outstanding loan amount. As you gradually pay off the money you borrow, you will be paying interest on a smaller loan amount and your interest payments will therefore slowly reduce. For example, your interest repayments when you first start paying off a $500,000 loan will be much larger than when you’ve paid off half of your principal amount.
- The number of days in the month. Most lenders calculate interest on home loans daily and then charge that interest to you each month. With this in mind, you could pay a smaller amount of interest in February (with 28 days in the month) than you do in March (with 31 days).
- The loan term. The time you take to pay off your loan will affect the amount of interest you pay – paying your loan off over a shorter period of time will minimise your interest repayments.
- Repayment frequency. Most lenders allow you to make repayments weekly, fortnightly or monthly, so the amount of interest you pay each time will vary depending on your repayment schedule. The more frequently you make repayments, the less interest you will pay on your loan. Use our bi-monthly calculator to see how your interest payments will vary depending on your repayment frequency.
- Whether you have an offset account. Some home loans come with a linked offset account, which allows you to reduce the amount of interest you pay on your loan. For example, if you borrow $300,000 from the bank but you have $50,000 on a linked 100% offset account, you will only pay interest on $250,000.
How is home loan interest calculated?
Interest on your home loan is generally calculated daily and then charged to you at the end of each month. Your bank will take the outstanding loan amount at the end of each business day and multiply it by the interest rate that applies to your loan, then divide that amount by 365 days (or 366 in a leap year).
Assuming you have an outstanding loan amount of $500,000 and an interest rate of 5% p.a., your interest repayment for one day would be calculated using the following formula:
($500,000 x 0.05) ÷ 365 = $68.49
At the end of the month, each daily interest charge is added together and then charged to your loan. To work out how much your interest repayments will be, input the details of your loan into our home loan interest calculator below.
Principal and interest vs interest-only
There’s another factor that can affect your regular home loan repayment amount: whether you are making principal and interest or interest-only repayments. Principal and interest repayments are the most common way to pay off a home loan, and they basically mean that one portion of your repayment goes towards paying off the amount you borrow and another portion goes to paying off the interest you owe.
However, some 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.
Susie’s Mortgage Repayments
Susie is borrowing $700,000 to buy a house and she wants to save as much money on interest repayments as she possibly can. After comparing home loans with 100% offset accounts, Susie decides to calculate just how much difference a 0.25% p.a. difference in interest rates could make to the total cost of a loan.
If she can find a loan with an interest rate of 4% p.a. on a 30-year loan term, her monthly principal and interest repayments will be $3,341.91. The total interest she will end up paying over the life of the loan is $503,086.54.
But if Susie finds a loan with a marginally lower interest rate of 3.75% p.a., her monthly repayments will be $3,241.81 and the total interest over the life of the loan will be $467,051.29 — that’s a total interest saving of $36,035.25.
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 actually 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.
- Make frequent repayments. The more frequently you make regular loan repayments, the less interest you will have to pay – so consider a weekly or fortnightly repayment schedule instead of a monthly one.
- Make extra repayments. The ability to make extra repayments without penalty is a good feature to look out for. The quicker you pay down your loan amount, the less interest you will need to pay on your smaller outstanding loan amount.
- 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, so choosing a 25-year loan term instead of 30 years can make a big difference.
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