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How to Calculate Home Loan Interest

Couple computing to save on their home loan interest

When it comes to saving on your mortgage, reducing the amount of interest you pay is crucial. Over your loan term, you need to repay the amount borrowed (the principal) and the interest. Interest is calculated as a percentage of the loan balance, normally at an annual rate.

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How Is Interest Calculated On a Home Loan?

Interest rates are typically calculated daily on the outstanding balance of the loan. Many factors affect how much interest you pay in total over the course of the loan term, which we’ll get into a little later.

To calculate your daily interest charge, multiply your loan balance by your interest rate and divide it by the number of days in the year. Some lenders will divide by 366 in a leap year. Then, if you repay your mortgage monthly, multiply by the number of days in the month. You can use our home loan repayment calculator to work out your estimated home loan repayments and see how much interest you will pay each month, fortnight, or week.

What Factors Affect the Amount of Interest You Pay?

Several factors will affect your interest rate and how much you pay. These include:

  1. Base interest rate
    The interest rate the lender charges you differs depending on your loan application and borrowing power – a strong deposit, good credit rating, and going through a mortgage broker can get you better interest rates. Make sure you meet the lending criteria and get your personal circumstances in the best possible position. For example, any credit card debt might result in a higher interest rate.

  2. The Reserve Bank Official Cash Rate
    Unless you have a fixed-rate home loan, the interest rate on your home loan will fluctuate. This is based on the official cash rate set by the Reserve Bank of Australia on the first Tuesday of every month, other than January. For instance, if the official cash rate increases by 0.5%, your lender might choose to increase your interest rate by 0.5%.

  3. Principal loan amount
    The principal amount is the amount of money you borrowed to pay for your property. In essence, the bigger the principal amount, the more interest you pay. Although, some lenders offer discounts for large loans.

    A higher deposit amount will lessen the amount you need to borrow from the bank to pay for your property.

  4. Outstanding loan amount
    Over time, the amount of interest you pay reduces. As there is a smaller outstanding loan amount, the interest payments will also be smaller.

    Regular extra repayments will reduce your outstanding principal loan and might help you to pay the loan off earlier.

  5. Days in the month
    As interest is calculated daily, you will pay more interest in months with more days. In February, with only twenty-eight days, your interest repayments will be lower than in March, which has thirty-one days.

  6. Loan term
    The longer your loan term, the more interest you pay as the principal accrues more interest over time. Switching to a shorter loan term or paying extra repayments will help you reduce the amount of interest that builds up.

  7. Repayment frequency
    Depending on your lender, you are usually able to make your home loan repayments monthly, fortnightly, or weekly. The more frequent your interest repayments, the lower each one will be.

  8. Offset account
    Some loans come with the offer of an offset account. If you put $50,000 in your offset account, your $300,000 mortgage is only charged interest on $250,000.

What Are LVR and LMI?

Your starting interest rate usually depends on how good your financial situation is when applying for your home loan. The LVR (loan to value ratio) is calculated based on your deposit. If you have a deposit of $100,000 for a loan amount of $500,000, the LVR would be 80%. Generally speaking, the lower your LVR, the more likely you will be offered better interest rates.

Most lenders will accept an LVR as high as 95%; however, they might require you to pay Lenders Mortgage Insurance (LMI) to protect them should you default on a payment.

What Home Loan Rates Are Available?

Lenders offer different home loan rates, depending on the type of mortgage you apply for. A variable rate home loan will typically have an interest rate of around 2.1%, which can fluctuate from month to month as the Reserve Bank’s official cash rate changes. There is also the option to apply for fixed-rate loans. Fixed-rate loan interest can range from around 2.04% to 2.84% and is typically set for between one to five years.

After the term of your fixed-rate loan is up, it automatically transfers into a variable rate loan for the duration of the loan term.

Interest Only Loan Vs. Principal and Interest

There is also the option to opt for interest-only loans or principal and interest loans. An interest-only loan is where you repay only the interest for a fixed period, usually between one and five years.

The advantage of interest-only loans is that your monthly repayments are reduced for the first few years of your home loan. However, you often pay more total interest over the entire loan term. Plus, the interest rate might be higher.

A principal and interest loan is where you make principal and interest repayments from the beginning of your loan term. You typically save interest and pay off your home loan sooner than an interest-only loan.

How Do I Save On Home Loan Interest?

There are several ways to save interest on your home loan. Whether you’re applying for a new home loan or looking to reduce the interest on your existing loan, follow our steps to reduce the amount of interest you pay. These include making additional repayments, using an offset account, increasing your repayment frequency, switching to a lower rate, and choosing a shorter loan term.

Make Additional Repayments

Paying off your mortgage faster reduces the outstanding loan principal and, therefore, minimises your interest charges. If you are able to make extra repayments, you will pay less interest overall. If you have a redraw facility on your home loan, you will be able to access any extra repayments if you should need to – although you might have to pay a fee.

Use an Offset Account

As mentioned, an offset account affects the amount of interest you pay each month. Not all lenders or mortgages let you have an offset account; however, you can significantly reduce the loan principal charged interest if you have access to one.

An offset account is the same as a simple transaction account that lets you deposit savings. Any amount kept in this account is then offset against your interest payments. They are a flexible, simple way of reducing each monthly payment. If you need the money in the account, you can withdraw it as you would with any other savings account.

It allows you to repay your loan far more quickly. With lower monthly repayments, you can make extra repayments and reduce the overall life of the loan. There are also tax benefits as the money in your offset loan account is not considered taxable income.

However, there may be ongoing fees. Double-check how much the lender is charging you for your offset account and whether the interest savings are worth it. Usually, to benefit from your offset account, you’ll need to deposit a large lump sum in there. Plus, your home loan might actually have increased interest rates.

If you’re interested in an offset account, chat with a mortgage broker at Lendstreet to see if it’s for you.

Increase Your Repayment Frequency

You will usually have the option to make your mortgage repayments monthly, fortnightly or weekly. More frequent repayments, generally, lower the overall repayment amount. As interest is calculated daily, the loan balance that your interest is calculated on will be a lower amount.

For instance, if you increase your principal and interest repayments to fortnightly, you might pay an extra month’s repayment each year. There are 26 fortnights each year. As you pay less interest, you will pay off more of the loan amount every two weeks. This also means that your mortgage will likely be repaid sooner.

However, it is a good idea to check how your lender calculates your loan repayments. While some lenders work out your fortnightly repayment amount by dividing your monthly repayments in half and asking you to pay this every other week. On the other hand, other lenders require you to pay the same amount, whether you make weekly, fortnightly or monthly payments.

Use our home loan repayment calculator to see.

Switch To a Lower Rate

In a highly competitive market, what might have been a low-interest rate when you first took out the loan, might now no longer be the best offer. It is a good idea to consider switching to lower interest rates a few times throughout the life of the loan. Shopping around is easier than you think; lenders are often keen to reduce the interest rate on your home loan to get you to stick around.

To get a better interest rate on your home loan, make sure you do the following:

  1. Research current interest rates.
  2. What interest rate is offered to new homeowners?
  3. Don’t be scared to ask your current lender for a better rate?
  4. Be prepared to change lenders.

Choose a Home Loan With a Shorter Loan Term

Whether you’re looking for your first home loan or considering refinancing your existing home loan, try to opt for a shorter loan term. While each of your loan repayments will be higher, you will pay less interest over the course of the home loan.

You should adopt the same strategy as when preparing to switch to a lower rate. Make sure you know what your lender’s competitors offer, and don’t be afraid to switch lenders.

If you don’t want to refinance, you can shorten your loan term by making regular extra repayments.

When Does My Home Loan Repayment Start?

Typically, mortgage payments are paid in arrears. You pay your first mortgage repayments one full month after the end of the month in which you bought the home.

Usually, mortgage repayments are taken every month on the first of the month.

So, if you close your home purchase on the 25th of March, you will begin paying back your home loan on the 1st of May. This monthly payment includes interest calculated every day from the 25th of March to the 1st of May. Therefore, you might pay more interest in your first month than you will generally throughout the rest of the loan duration.

Can I Change My Repayments After I've Taken a Loan Out?

Depending on your lender and current loan details, you might be able to change your repayment plan by reducing or pausing your payments.

You might be able to pause your repayments if you have a variable rate loan, you’re paying principal and interest, and you’re ahead on your repayments. However, you will lose the benefits you’ve gained from making extra repayments on your home loan. Plus, interest will continue to accrue while your payments are halted. There might also be the option to reduce your repayments.

If you want to refinance your loan to get better interest rates, speak to a mortgage broker today about refinancing home loans.

What Is a Comparison Rate?

All lenders with an Australian credit licence must show a comparison rate. As the interest rate is not the only thing that impacts home loans, the comparison rate shows other bank fees and the total cost of the loan compared to others.

While looking for home loans with low-interest rates is important, lenders might increase other costs, such as an annual package fee or ongoing fees. The comparison rate aims to help you deduce the true cost of the home loan based on all factors. If you’re unsure about how to compare home loans, seek independent advice from a broker.

In Summary

Paying a home loan interest rate is inevitable for getting a mortgage and purchasing a property. While you should prioritise looking for a low-interest rate, you shouldn’t ignore other fees and charges. Interest is usually based on your borrowing power, financial situation and the market interest rate.

There are several ways to reduce your interest payments, such as improving your LVR or applying for a fixed interest rate. With an existing home loan, you could think about refinancing to get better loan terms. Consider your personal objectives and own circumstances before speaking to a broker about your home loan options.

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FAQs

What Is the Formula for Calculating Interest On a Home Loan?

To calculate the total interest, follow this formula:

Principal loan amount X interest rate X loan term (in years) = total interest amount

Remember that interest is calculated daily, based on the outstanding loan amount.

How Do You Calculate Monthly Interest On a Mortgage?

To calculate the monthly mortgage repayments, you’ll need the monthly interest rate. Most interest rates are “per annum” (p.a), so you will need to divide this by twelve. For example, an interest rate of 2.5% is 0.208% per month. Then, multiply this percentage by the remaining loan amount to estimate how much interest you will pay that month.

How Do I Calculate Interest On a Loan?

You can use a home loan calculator to get an estimate of how much interest you will pay over the course of the loan term and how much you will pay each month, week or fortnight.

How Do You Calculate Simple Interest Daily?

To get the daily interest rate, divide the annual interest rate by 365, then multiply by the principal amount to calculate how much interest you will pay each day. Remember to express the interest rate as a decimal, so 2.5% will become 0.025. With a loan amount of $500,000, the daily interest amount is $34.25.

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