There are two parts to a mortgage repayment: the principal and the interest. You pay back both 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 original loan amount. Some lenders calculate your interest charges daily, or monthly.
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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 3.00% p.a., your interest repayment for one day would be calculated using the following formula:
- ($500,000 x 0.03) ÷ 365 = $41.10
To work out the monthly interest charges, multiply the daily interest charge by the number of days in the month.
- $41.10 x 30 = $1,233 monthly interest charge
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.
If my loan principal reduces over time, why do my repayments stay the same?
There are 2 parts to the loan repayment: interest and principal. Lenders spread out the interest charges over time, charging more interest early on. This means you repay less of the principal and more interest.
As time goes on you pay less in interest and pay off more of the principal. This is called an amortisation schedule.
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 3% p.a. Some loans offer 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 current cash rate can be found here.
- The amount you borrow. The larger the sum you borrow from your bank, the more interest you will pay – but also, some banks offer discounted interest rates for larger loan amounts.
- 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 the principal amount, and interest is only payable on $250,000.
- 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.
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
In our hypothetical case study, Susie is borrowing $700,000 to buy a house. Like most borrowers, 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 3% p.a. on a 30-year loan term, her monthly principal and interest repayments will be $2,951. The total interest she will end up paying over the life of the loan is $362,442.
But if Susie finds a loan with a marginally lower interest rate of 2.75% p.a., her monthly repayments will be $2,858 – a saving of $93. The total interest over the life of the loan will be $467,051.29 — that’s a total interest saving of $33,480.
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, by literally "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 – so 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, as 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, so choosing a 25-year loan term instead of 30 years can make a big difference to the amount of interest you pay overall.
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