How is interest calculated on my home loan?

If you understand how the interest is calculated on your home loan then you might be able to find ways to save on your repayments. So let’s take a closer look at some of the options.

When you take out a home loan, you need to repay the principal (the amount borrowed) plus interest. Interest is what a lender charges you to borrow the money.

The interest is calculated as a percentage of your loan balance and is typically expressed as an annual rate. That’s why the interest rates are shown with the letters ‘p.a.’ or per annum.

How is interest calculated on a home loan?

Interest on a home loan is generally calculated on a daily basis on the outstanding balance of the loan. Your loan repayment is usually charged on a monthly basis, although there are ways you can change this to potentially save money, which we’ll explore later.

As a hypothetical example, if you had a home loan balance of $400,000 at 5.00% p.a. (based on a borrower with an LVR of 80%, comparison rates vary depending on the product), your monthly interest charge would be:

• $400,000 x 0.05 / 365 = $54.79 daily interest (rounded out)
• $54.79 x 31 days in May (this month, for example) = $1,698.49 interest for May

Your loan may be calculated in a different way depending on who you bank with, so it’s important to check how they work the interest on your loan. For example, some lenders – such as Bendigo Bank – may divide the annual interest rate by 366 days during leap years, some just stick to 365 days – such as the Commonwealth Bank.

The amount you’ll usually be required to repay each month will be more than just the interest alone (unless you have an interest-only home loan) as your repayment will go towards both the amount you borrowed (the principal) and any interest. The repayment figure is based on a much more complicated formula, so again, check with your lender to see how that works. Other fees and charges may also apply.

To get an estimate of how much you’ll need to repay, including the interest over the life of a home loan, you can use Canstar’s mortgage repayment calculator.

What factors can affect the interest on a home loan?

How much interest you pay on your home loan will depend on a range of factors, including the loan amount, interest rate, loan term, repayment frequency and whether you make any extra repayments or make use of an offset account, if your lender has this option.

Variable vs. fixed vs. split interest rate

Some lenders offer home loans on a variable interest rate or fixed interest rate, or you may be able to split your loan so a portion of your loan has a fixed rate and the rest has a variable rate.

With a variable rate home loan, your interest rate can rise or fall throughout the term of your loan, depending on a number of factors such as the Reserve Bank of Australia’s official cash rate.

With a fixed rate home loan, your interest rate is locked in for a certain period of time. That’s usually between one to five years, although periods of up to 10 years are possible.

With a fixed rate there is always a risk that the variable rate may fall, so you could be locked in to a loan paying more than you would on a variable rate. Should the variable interest rate rise, then you may be better on your fixed rate loan.

If you take the split option to fix only part of the home loan for a set period, you can use Canstar’s split loan calculator to work out what your monthly repayment and total interest might be.

The interest rate

The interest rate on a home loan can make a big difference to the total amount of interest you pay over time.

For example, let’s use Canstar’s mortgage calculator to work out the total interest on our $400,000 loan with an interest rate of 5.00% p.a.. With monthly principal and interest repayments over a loan term of 30 years, when you crunch the numbers you find the total interest payable is $373,023.

But if the interest rate was one percentage point lower – at 4.00% p.a. – the total interest payable over the 30 year term would be $287,478, a saving of $85,545. If the interest rate was one point higher at 6.00% then the total interest would be $463,353, an extra $90,330.

Principal and interest vs. interest-only repayments

You may be able to make interest-only repayments on your loan for a period of time which would reduce your monthly repayment figure. But as you won’t be paying down any of the principal during this time, this means you’ll generally pay more interest compared to if you were making principal and interest repayments.

The Australian Government’s Moneysmart website says you may have to pay a higher interest rate on an interest-only period than you would for a principal and interest loan, so “you pay more over the life of the loan”.

How to save on your home loan interest

If you’re looking to reduce the amount of interest you’re paying on your home loan, there are a few options you may consider, based on your personal needs and circumstances.

1. Make additional repayments on your home loan

If you’re able to make additional repayments on your home loan, above the minimum amount, this will reduce your principal amount faster and will lower your interest charges. If you have access to a redraw facility, you’ll also be able to access any extra repayments if you need to (although a fee may apply).

You can use Canstar’s extra home loan repayments calculator to give you an idea of how much you could save by making extra repayments over the life of your loan.

For example, with our $400,000 loan at 5.00% p.a. over 30 years, Canstar’s home loan repayment calculator says the minimum monthly repayment would be $2,147. If you could pay an additional $100 each month over the term of the loan, the extra repayments calculator says you would pay it off two years and 10 months earlier and save $41,557 in interest.

2. Use an offset account to reduce your home loan balance

If you have a home loan with an offset account, you can use this to pay less interest. An offset account is usually a transaction account you use for your everyday banking, but linked to your loan so that its balance helps offset your home loan balance.

In other words, you’re only charged interest on the difference between your loan balance and the amount in your offset account.

For example, if you had $10,000 in a 100% linked offset account, you would only pay interest on the outstanding balance of your home loan, minus the $10,000 of your offset account balance. Clearly the amount in your offset account would vary, so its impact on your home loan interest payments would vary as well, but it’s a way to reduce those regular repayments.

The Macquarie Bank suggests you consider putting any savings you have into your offset account, as the interest it could save on your home loan could be more than any interest you’d earn if the money was invested elsewhere in a savings account or term deposit.

“This may seem counterintuitive if you’re used to locking away your savings into a high interest account,” the bank says on its website.

“However, because your home loan interest rate is likely to be higher than the rate on your savings account, and you’ll pay income tax on the interest you earn, putting your extra funds into an offset makes much more sense.”

You’d need to do your own calculations to see what works best for your situation.

3. Increase the frequency of your home loan repayments

Some lenders offer you the option to make your regular repayments monthly, fortnightly or weekly.

By switching to a more frequent repayment schedule, you’ll generally be paying less interest. This is because interest is calculated daily and the balance that your interest is calculated will reduce more quickly over time.

If you switch to fortnightly repayments and pay half your regular monthly repayment each time,  you’ll effectively be paying the equivalent of one extra month’s repayment each year. That’s because there are 26 fortnights in a year, hence you’re paying the equivalent of 13 calendar monthly repayments.

As lenders may take different approaches to calculating home loan repayments, it’s a good idea to check how your lender calculates fortnightly repayments to see whether this will be the case for you.

4. Switch to a home loan with a lower interest rate

The Australian home loan market is highly competitive and interest rates can change over time. So what might have been a low rate when you took out the home loan could now be out of step with the rest of the market.

Many lenders offer incentives to customers who’re looking to refinance their home loan. Your own lender may be more likely than you think to offer you discounted rates and favourable terms to keep you.

Some of the steps you can take to get a better rate on your home loan include:

1. doing your research on the current rates
2. finding out what rates new home owners are getting
3. not being afraid to ask your lender for a better rate
4. being prepared to switch banks.

5. Choose a home loan with a shorter loan term

Another way to potentially save interest is to switch to a home loan with a shorter loan term. This will reduce your interest in the long term. But keep in mind you’ll need to make higher regular repayments.

For example, with our $400,000 home loan at 5.00% p.a., you can use Canstar’s mortgage repayment calculator to see what the total interest and regular repayments would be on a term of 25 years. The monthly repayments would be $2,338 and the total interest would be $301,508. That’s $191 extra a month but a total saving of $71,515 in interest than if the loan term was 30 years.

Whether you’re considering refinancing your loan or taking out your first home loan, you might like to compare your options with Canstar. Canstar compares hundreds of loans based on both price and features.

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