What is principal and interest on a home loan?
The money you borrow to buy a home is called the loan principal. The interest is what the lender charges on top.
Principal is the amount of money you have borrowed from the bank (minus your repayments). Interest is the money charged on top of the principal and is calculated based on the interest rate and the size of the principal.
Most home loans require principal and interest repayments. This means your repayment is divided into two portions. Some is sent towards paying off the interest due on your outstanding loan amount, while the remainder goes towards paying off the outstanding loan amount itself.
Principal and interest versus interest only repayments
The alternative to principal and interest repayments is interest only repayments. With an interest only home loan you only repay the loan interest in the beginning of the loan. This makes your repayments smaller at first. But later on you must repay the loan principal too, so you will end up paying more in the long run.
Why can the amounts of interest and principal I pay change over the course of my loan?
When you start making mortgage repayments you might notice that most of your repayment is paying off the interest interest at the beginning of the loan. Only a small amount will go towards the principal. As you continue paying off the loan you'll pay off more principal and less interest.
Look at the two graphs below, based on a $250,000 loan at 5.70% p.a. over 25 years.
In the first month of repayments you’re paying interest on the whole amount you’ve borrowed, but as this amount is paid off over the years, the interest due is smaller.
But if you’re paying less interest and the principal is getting smaller, why are your repayments not getting smaller?
This is because your lender has worked out exactly how much you’ll need to spend on each repayment to pay off your loan in the term you’ve agreed to. The result of these calculations is called an amortisation schedule. The schedule shows how much of your payments go towards interest and how much goes towards principal payments and this will show that the amount that goes towards paying off the principal gets bigger as the years go on and does so at a faster rate.
Why do we pay interest?
A lender is a business, and like any other business it wants to make a profit. The interest you pay is part of their profit.
To answer why the interest we pay fluctuates we first need to know where lenders get the money they lend from.
When you apply for a loan, your lender will source funds for you from a range of places. According to the Reserve Bank of Australia (RBA) almost half of this now comes from the domestic market. This means some of your loan money will be made up of funds taken from other Australian’s savings and term deposit accounts.
The other portion is borrowed from wholesale lenders, which can be from sources such as superannuation funds or other investment funds looking for safe investments.
When your lender's funding costs increase, they typically charge more interest to borrowers. The cash rate set by the RBA each month also has a significant bearing on how much interest is paid. This is why your repayments can fluctuate each month.
If the RBA lowers the cash rate, it could become cheaper for lenders to source funds for loans and therefore lenders may lower their interest rates. It’s part of the reason why a continual comparison of the other loans in the market is always necessary.
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