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How is interest on a home loan calculated?

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When taking out a loan, you’re expected to pay back not only the borrowed amount but also the interest. This mortgage interest, also called the annual percentage rate (APR), is charged by the lender.

Your lender takes the balance of your loan and multiplies it according to your rate to calculate the interest for each monthly instalment. It’s the price you pay for borrowing the lender’s money.

But how is the interest rate on your home loan determined and how is it calculated? In this article, we explain the basics of mortgage interest rates and how they affect your repayments.

How is your home loan interest rate determined?

As a borrower, you will generally have the flexibility to choose which lender you’ll be getting your home loan from - and interest rates can vary based on the lender. Your lender will offer different interest rates that could be determined by a number of factors including:

  • Loan purpose (owner occupied vs investment)
  • Repayment type (principal and interest vs interest only)
  • Rate type (fixed or variable)
  • Product type (for example, some lenders may offer ‘discounted’ loan products)
  • Loan features (for example, a loan with an offset sub account may have a higher interest rate compared to a basic home loan).
  • LVR (you may find a lower interest rate for your home loan if you have a lower LVR)
  • Serviceability

Interest rates can vary between lenders, so it’s always a good idea to do your own research and comparison to find a lender with a loan that suits your own personal circumstances.

How to calculate home loan interest repayments

The exact interest cost can depend on various factors. You can figure out how much interest you pay each month once you have the following information:

  • The principal loan amount
  • The interest rate
  • Your repayment type

Calculating the interest rate per month on a home loan takes a bit of number crunching. You can use the following as a rough guide to calculating your indicative interest repayment.

Lets say you take out a $100,000 home loan over a 30 year term, on an interest rate of 6.00%. To obtain the indicative monthly interest charge, the following steps can be used:

  • Convert the interest rate to a decimal by dividing the percentage by 100.
    • 6.00% would become 0.0600
  • To obtain the annual interest charge, multiply your loan balance by the decimal interest value.
    • $100,000 * 0.0600 = $6,000 annual interest cost
  • Many lenders will calculate the interest on a daily basis, and charge it monthly. To calculate the daily interest cost, divide the annual interest cost by 365 (days in the year).
    • $6,000 / 365 = $16.44 daily interest.
  • Now you can multiply the daily interest charge by the number of days in the month to calculate the monthly interest charge on your loan.
    • Using a 31 day month, $16.44 * 31 = $509.64 indicative monthly interest.

* Note that the above is only for demonstrative purposes.

While the above is the calculation for the monthly interest repayment, if you are making principal and interest repayments, you will also be required to pay back a portion of the principal balance of your loan along with your interest each month.

Understanding how your home interest is calculated can help you get a better handle on your mortgage. To make things easier, use loans.com.au’s online home loan calculator. This handy tool gives you an idea of what your repayments could look like. You can adjust the loan amount, interest rate, loan type, and loan term to see how each factor affects your repayments.

What factors influence the amount of interest you pay?

The balance of your principal influences your interest, as does the annual rate you're charged. Other factors that affect the interest you pay include:

  • The type of home loan you have.

Variable-rate home loans have potentially-fluctuating interest rates. The interest rate for this type of home loan changes based on factors such as the Reserve Bank's cash rate and funding costs. On the other hand, a fixed rate mortgage will allow you to guarantee the rate on your home loan won’t change for the selected fixed term, usually between 1-5 years.

  • The length of your home loan.

The longer your loan is, the more interest you pay overall. One of the ways you can reduce the overall cost of the loan is by taking out a shorter loan term, so you’ll pay fewer years' interest, and lower the interest faster by getting the balance down more rapidly.

  • Your repayment frequency.

Many lenders will allow you to make either monthly, fortnightly, or weekly repayments to suit your schedule. If you’re paying weekly or fortnightly, you may be reducing the principal loan amount much more quickly than if you’re making monthly repayments. With more frequent repayments, the interest calculated on your remaining loan balance will be lower. Note that loans on interest only repayments will likely be required to have a monthly repayment schedule.

  • Making extra payments

Aside from frequent payments, you can also reduce the overall interest charged on your loan by making early payments or providing a lump sum payment. Additional payments help lessen the interest on your loan because they reduce your principal debt. This can also shorten your loan term which means paying less interest over the life of the loan.

  • A mortgage offset sub-account

Many lenders will offer an offset sub-account feature, which is a transactional facility linked to your home loan. Offset sub-accounts generally act as a standard transactional account, however it is a facility linked to your loan. This account lets borrowers offset the amount they owe on their mortgage. The interest you pay on your home loan is calculated based on the reduced amount.

If you have a $100,000 home loan, for example, and deposit $10,000 in the offset sub-account, you’ll be charged interest on the difference, being $90,000 only. The money you have in the offset sub-account works to reduce the interest charged on your loan.

What’s the difference between interest-only and principal & interest loans?

Aside from interest rates, home loans can vary in methods of repayment as well. Understanding the difference between interest-only loans and principal & interest loans can help you decide which one you’re better suited for.

Interest-only home loans

When you make repayments on an interest-only home loan, you’re only paying off the interest. You’re not paying towards any of the principal amount or lessening your loan balance. After the interest-only period ends, you’ll start making payments towards the principal including interest fees.

Interest-only home loans offer lower repayments during the interest-only period. However, the total interest you pay over the life of the loan could be higher.

Principal & interest home loans

Unlike an interest-only loan, you’ll be paying off your principal debt immediately plus interest. The repayments may be higher compared to interest-only loans, but you may be paying less interest over the life of the loan. With a principal & interest home loan, you could pay off your loan faster because there is no interest-only period.

Does the mortgage interest rate affect the comparison rate?

The comparison rate is the full cost of a home loan. The interest rate does affect the comparison rate, however, it doesn’t provide the whole picture. The comparison rate includes the interest rate, upfront fees, ongoing fees, and discharge fees. If you want to know the true cost of a home loan, look at the comparison rate.

Looking for a good, low-rate home loan?

Talk to us at loans.com.au by calling 13 10 90 or get in touch online! Our friendly lending specialists are more than happy to assist you with your mortgage needs. Whether you’re applying for a home loan or want to refinance, we’re here to help!

About the article

As Australia's leading online lender, loans.com.au has been helping people into their dream homes and cars for more than 10 years. Our content is written and reviewed by experienced financial experts. The information we provide is general in nature and does not take into account your personal objectives or needs. If you'd like to chat to one of our lending specialists about a home or car loan, contact us on Live Chat or by calling 13 10 90.

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