How is interest on a home loan calculated?

When you borrow money to buy a new home or make another investment by leveraging your property as collateral, the price of using these funds is called interest. This fee is charged as a percentage of your balance until you've paid back the total amount owed.

Your monthly payments typically consist of both interest and principal (what's left of your loan). Even though the amount you pay each month may remain the same, the proportion that goes towards interest compared to principal will fluctuate over the life of the loan. In some cases, people make interest-only payments for a period of their loan periods, which simply means they're only paying off the year's interest and not any of the principal.

It can be a little confusing to understand how exactly this all works and how interest is calculated for your home loan. Although you can always use a home loan calculator to see how much you owe and what portion is going towards interest versus principal, it's a good idea to have a solid sense of what's going on.

As you settle into your new home, take a moment to understand how mortgage interest works.

What is mortgage interest?

Let's start with the basics: What is interest? As noted, it's essentially the price you pay for using your lender's money. When you take out a loan, you'll notice that it comes with a certain interest rate, called the annual percentage rate (APR). Basically, your lender takes the balance of your loan and multiplies it according to your rate to calculate the interest for each monthly instalment.

For example, if you take out a $100,000 loan, your principal starts at $100,000. If your loan has a 4.01 per cent interest rate, you're paying $4.01 cents annually for every $100 you owe. Because your balance usually decreases over the course of the year, however, you won't pay 4.01 per cent of $100,000, but a slightly smaller amount. That's because interest is calculated based on the balance each month.

In some cases, if you haven't paid off all the interest in a year, it'll be added to the principal, which means the next year you'll be paying interest on that amount in addition to the loan balance.

Which factors influence how much interest you pay?

As you can see from the maths above, the balance of your principal influences your interest, as does the annual rate you're charged. Some home loans have what's called a variable interest rate, which means that percentage can change based on factors such as the Reserve Bank's cash rate. Other mortgages have one fixed rate for the life of the loan, while some people split their home loan to include both variable and fixed interest payments.

The length of your mortgage (how long you take to pay it back) will also influence the total amount of interest you'll pay since interest is charged each year.

The length of your loan affects how much you'll pay in interest.

One of the ways you can reduce the overall cost of the loan is by increasing your monthly payments above the minimum required. This can shorten the duration of the loan, meaning you will pay fewer years' interest, and lower the interest faster by getting the balance down more rapidly.

By plugging in different payment amounts on a home loan calculator, you can see the impact that adjusting your monthly instalments can have on your total interest costs. Some calculators also allow you to assess the effect of offsets, lump sum payments, extra repayments and different interest rates - all of which can affect the interest you'll pay over the life of the mortgage. You could use this information to help you develop strategies to better manage your loan repayments and plan for mortgage refinancing if you choose to pursue this option.

How to calculate home loan interest rate?

To figure out how much interest you pay each month, you need to know the following:

• The principal
• The interest rate
• Your monthly payment amount

The calculation is fairly simple. First, take the interest rate and convert it into a decimal by dividing it by 100. For example, a 4.01 per cent APR becomes 0.0401. That's the rate for the whole year, though, and you want to know what it is per month. Therefore, divide it by 12. In our hypothetical case, we get 0.0033416. That's your monthly rate in decimal form.

Now, multiply your principal balance by this amount. Taking a $100,000 loan would cost you $334.16 in interest the first month. Let's say your repayment amount is $477.99 per month. The first month, $334.16 would go towards interest, leaving $143.83 to pay down the principal. Your balance after Month 1 is $99,856.20 and that's the principal you use to calculate the interest for the next month. ($99,856.20 x 0.0033416 = $333.68 in interest, leaving $144.31 towards principal.)

Crunching some numbers can help you seize control of your mortgage.

As you can see, even from one month to the next in this example, the amount you're paying towards interest has decreased. You could extend these calculations to determine the total amount of interest you'll pay as you complete the loan, but you might also want to see how adjusting your payment amount or making additional instalments within the year could influence your costs. Keep in mind that your rate can change if you have a variable rate mortgage.

While it's great to know how to figure these values manually, the easiest way to assess the bigger impact of these variables is by using a trusty home loan calculator. This information may also help you better assess different types of loans so you can choose the one that best fits your individual needs. As always, if you're unsure about anything to do with your mortgage (whether you have one or are looking to attain one), don't hesitate to speak with an advisor, such as one of the experts at loans.com.au.