How is interest calculated on your home loan?

Understanding how interest is calculated on your home loan helps you make informed financial decisions. Find out how to lower the interest you pay.
joseph@itssimple.com.au

joseph@itssimple.com.au

December 29, 2022

interest calculated on your home loan

Interest rates are one of the most important factors to consider when buying a home, so knowing how interest is calculated on your home loan can help you make more informed financial decisions and better manage your debts.

Here, we cover what home loan interest rates are, how lenders calculate the interest on your mortgage and ways you can save on the interest you will pay over the life of the loan.

What is the interest rate?

what is the interest rate

When you apply for a home loan in Australia, you need to pay the principal amount (the money you borrowed) plus the interest. In simpler terms, interest is a percentage of your loan that your lender charges you for borrowing money.

The amount of interest you pay is charged to your principal. This means that the larger your loan is, the more you pay over the life of your loan.

For example, you take out a 25-year mortgage worth $500,000 at an interest rate of 5.25%. Aside from paying the principal loan amount, you also need to pay the interest amounting to approximately $398,872 for over 25 years, meaning your property will cost you around $898,872 overall.

Principal and interest vs interest-only

Since your loan is made up of two parts (principal and interest), you have the option to either make principal and interest repayments or interest-only repayments.

Principal and interest repayments mean that your weekly, fortnightly or monthly repayments include both the amount you borrow and the interest charged by your lender.

Meanwhile, interest-only repayments allow you to only pay the interest for a certain period. Then, you switch to paying interest and principal.

To help you estimate your home loan repayments, you can easily use our loan repayment calculator.

Fixed, variable and split rates

Aside from choosing your repayment schedule, you also have to take note of fixed, variable and split rate loans.

A fixed rate means that you lock your interest rate for an agreed period (usually 1-5 years). This type of mortgage tends to have a higher interest rate, but it provides security and peace of mind in case the cash rate increases. However, it has limited loan features, and you may not benefit in case the cash rate drops.

On the other hand, a variable rate fluctuates based on the market and the cash rate set by the Reserve Bank of Australia. This means that if the cash rate increases, so will your interest rate, but it will drop if the cash rate declines over the life of your loan.

A variable rate offers flexibility as it allows you to access loan features, including offset accounts and redraw facilities, and make extra repayments. But it can negatively affect your budget if the rates change aggressively.

If you’re torn between the two choices, you can always go with a split loan. As the name suggests, you can fix a portion of your loan and allot the remaining to a variable rate. For example, if you take out a $600,000 home loan, you can have a fixed rate on the $400,000 and a variable rate on the $200,000.

How do banks calculate interest on your home loan?

how do banks calculate interest on your home loan

Typically, the home loan interest is calculated daily based on your outstanding balance. Your lender will multiply your outstanding loan amount by the interest rate on your loan.

This is then divided by 365 (366 in a leap year) to calculate your daily interest charge. Then, the daily interest charge is usually multiplied by the number of days in the month to get the monthly interest amount.

To illustrate, suppose your outstanding balance is $300,000 at an interest rate of 4%:

Daily interest: (300,000 x 0.04) ÷ 365 = $32.88

Monthly interest (if there were 30 days in the month): 32.88 x 30 = $986.30

What affects the interest you pay?

Overall, the interest on your home loan depends on a range of factors, such as the cash rate, mortgage interest rate, amount you borrowed, term of the loan and more:

Official cash rate

The interest on a home loan is influenced by the RBA’s official cash rate. While banks and lenders are not required to pass on the full rate hike or drop to you, they base their interest rates, especially variable rate loans, on the cash rate. So, the higher the cash rate is, the more borrowing becomes expensive.

Principal amount

As mentioned, the principal amount is the sum you borrow. The bigger your loan is, the more interest you pay. However, some lenders offer discounted rates on higher loan amounts.

Outstanding loan balance

Another factor that influences how much mortgage interest you pay is your remaining balance. As you gradually pay off your loan, you decrease the interest on your loan amount and your repayments.

Loan term

The loan term refers to the duration you pay your loan. Paying off your loan over a shorter term minimises your interest repayments. For example, if you borrow $800,000 at a 4% interest rate, the total interest you pay for over 30 years is $574,957. However, if you pay it in 25 years, the interest costs you $466,809 over the life of your loan.

Repayment schedule

Usually, lenders offer weekly, fortnightly or monthly repayments. The more frequently you pay off your loan, the less interest you accumulate. Taking the previous example, if you make weekly repayments instead of monthly, you pay $465,865 instead of $466,809.

Purpose of loan

If you’re planning to get an investment property, the type of your loan also affects your interest. Lenders usually charge higher interest rates on investment loans compared to owner-occupied loans since they are riskier.

Tips to save on the interest rate on your home loan

Now that you know how your interest is calculated, you can do some things to lower your rate or the interest you pay over the life of your loan:

tips to save on the interest rate on your home loan

Use an offset account

An offset account is a bank account directly linked to your home loan. If you have an offset account, the money you deposit in this account is offset against your principal loan. Assuming you have a $600,000 loan and $40,000 in your offset account. Your lender will charge interest on $560,000 instead of $600,000. This helps you save money on the total interest you pay.

Make extra repayments

Another way to save on the interest is to make additional repayments when you can. Whether it’s putting a little extra or a lump sum towards your home loan, making extra repayments decreases your principal loan. In turn, the overall interest you pay also goes down, and you pay off your loan earlier.

Increase repayment frequency

If you can’t make extra repayments, another option is to pay more frequently. Since some lenders calculate your interest daily, the more often you pay off your loan and lower your principal mortgage, the less interest you pay. So, you may consider switching from monthly to fortnightly or weekly repayments to pay less interest.

Shorten your loan term

Switching to a shorter loan term can also make a huge difference in your mortgage repayments. While a shorter term means your monthly repayments cost more, it can reduce the interest you pay over the lifetime of your loan.

For example, a $1 million loan at a rate of 4.50% costs you $824,068 for 30 years but only $518,359 if you pay it in 20 years. This ultimately saves you $305,709 in interest payable.

Refinance to a lower rate

The market is highly competitive, so finding a lender that offers a better rate is possible. You can do your research or consult with expert brokers, check out what other lenders offer or negotiate your rate with your current lender.

If you’re in a great position to refinance your loan to a lower rate with better features, switching to a low-rate home loan can help you save on interest.

To give you an idea, a 25-year mortgage worth $600,000 at a rate of 4.85% costs you a total of $436,592 in interest. However, if you manage to refinance to 4.50%, you only pay $400,499 in interest and save over $36,093.

Looking for a low interest home loan in Australia?

Several factors impact the interest on your home loan, so understanding how banks and lenders calculate your interest rate gets you a step ahead. You can make better financial decisions, know what you can do to lower your interest payments and potentially secure a lower interest rate.

To prepare and control your finance, get in touch with our mortgage brokers to get expert help from the start and beyond. It’s Simple will help you break down your options, enjoy tailored choices from the top 40+ banks and lenders in Australia and help you choose and apply for the right loan solutions that match your goals and needs.

You can email us today at info@itssimple.com.au or book a free expert consultation at your preferred schedule.

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