How is interest calculated on your home loan?

Did you know there are several ways you might be able to save interest on your home loan? Grab your calculator and let’s take a look.

When you take out a home loan, you need to repay the principal (the amount borrowed) plus interest. Interest is what a lender charges to let you borrow money. It’s calculated as a percentage of your loan balance and is typically charged at an annual rate. It’s why many 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. How much interest you end up paying on your 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 loan has this option.

Practically, the calculation typically involves multiplying your loan balance by your interest rate and dividing this by 365 days (some lenders divide by 366 days during leap years). This is your daily interest charge. This is then usually multiplied by the number of days in the month to work out your monthly interest amount.

Interest calculated home loan (1)
Source: GaudiLab (Shutterstock)

What home loan rates are available?

Home loans can offer a variable 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 fixed rate home loans, your interest rate is locked in for a certain period of time (usually between one to five years). With variable rate home loans, your interest rate can rise or fall throughout your loan term, depending on a number of factors such as the Reserve Bank’s official cash rate.

Your home loan interest rate can make a big difference to the total amount of interest you pay.

Example

As a hypothetical example, if you had a loan balance of $400,000 at the current average standard variable rate in Canstar’s database of 3.54% p.a. (based on a borrower with an LVR of 80%, comparison rates vary depending on the specific product chosen), your monthly interest charge would be:

  • $400,000 x 0.0354 / 365 = $38.79 interest per day
  • $38.79 x 30 days in June = $1,163.84 interest for June month

The lowest standard variable rate in Canstar’s database is currently 2.39% p.a. (based on a borrower with an LVR of 80%, comparison rates vary depending on the specific product chosen). If you had a loan balance of $400,000 with an interest rate of 2.39% p.a., your interest charge would be:

  • $400,000 x 0.0239 / 365 = $26.19 interest per day
  • $26.19 x 30 days in June = $785.75 interest for June month

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

You can use Canstar’s mortgage calculator to get an estimate of the total interest you’ll pay over the life of your loan and how much your monthly repayments will be.

Ways to save on home loan interest

If you’re looking to pay less interest on your home loan, there are a few options you may consider, based on your personal needs and circumstances:

1. Make additional repayments

If you are able to make additional repayments above the minimum amount, this will reduce your principal amount 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).

To give you an idea of how making extra repayments could save you money in interest over the life of your loan, you might like to use Canstar’s home loan extra repayments calculator.

2. Use an offset account

If you have a home loan with an offset account, you can use this to pay less interest. An offset account is a transaction account linked to your loan that offsets your home loan balance. In other words, you are only charged interest on the difference between your loan balance and the amount in your offset account. For example, if you had a loan of $400,000 with $50,000 in a linked 100% offset account, you would only pay interest on $350,000 of your balance.

3. Increase your repayment frequency

Some lenders offer you the option of making your 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 usually calculated daily and the balance that your interest is calculated on will be lower.

If you switch to fortnightly repayments, for example, you may also pay the equivalent of one extra month’s repayment each year. This is because there are 26 fortnights in a year. With less interest, more of your repayments will pay off the principal of your loan, meaning your mortgage will be repaid sooner.

As lenders may take different approaches in calculating 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. For example, some lenders calculate fortnightly repayments by dividing your monthly repayments in half and you pay this amount every two weeks. Other lenders, calculate repayments so that you pay the same amount if you pay fortnightly or monthly.

Calculate interest home loan
Source: GaudiLab (Shutterstock)

4. Switch to a lower rate

The Australian home loan market is highly competitive, and with rates changing regularly, what might have been a low rate when you took out the loan could now be out of step with the rest of the market. Lenders may be more likely than you think to offer you discounted rates and favourable terms to keep you around.

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. However, keep in mind that you will need to make higher regular repayments.

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.

The comparison tables below display some of the variable rate home loan products on Canstar’s database with links to lenders’ websites, for borrowers in NSW making principal and interest repayments on a loan of $350,000 with an 80% LVR. You can choose between the refinance, first home and investing tabs to view results most relevant to you. The results are sorted by ‘current rate’ (lowest to highest). Before committing to a particular home loan product, check upfront with your lender and read the applicable loan documentation to confirm whether the terms of the loan meet your needs and repayment capacity. Use Canstar’s home loan selector to view a wider range of home loan products.

Lowest interest rates for refinance home loans

*Comparison rate based on loan amount of $150,000. Read the Comparison Rate Warning.

Lowest interest rates for first home loans

*Comparison rate based on loan amount of $150,000. Read the Comparison Rate Warning.

Lowest interest rates for investing home loans

*Comparison rate based on loan amount of $150,000. Read the Comparison Rate Warning.

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