When you take out a home loan, you need to repay the amount you borrowed plus the interest charged by the lender. But how is interest calculated on your mortgage? And is there anything you can do to pay less interest over the life of your loan?

How is interest calculated on a home loan?

In most cases, lenders calculate interest on your home loan daily. They do that by multiplying your loan’s interest rate by the outstanding balance. This amount is then divided by 365 days to give a daily interest charge. If it’s a leap year, some lenders divide by 366 while others don’t.

At the end of the month, all these daily interest calculations are added up and charged to your account.

What’s the difference between fixed and variable rates?

If you have a fixed rate home loan, your interest rate doesn’t change for a set period (usually between one to five years).

However, variable home loan rates can go up and down, usually in line with any changes to the official cash rate or a lender’s cost of funds (BBSW).

What can influence the amount of interest you pay?

Several factors can affect how much interest you pay over the life of the loan. These include:

• The home loan’s interest rate – The interest rate is how much a lender is charging you each year to borrow money. So, the higher your rate, the more expensive your loan.

• The official cash rate – This is set by the Reserve Bank of Australia (RBA) and is the rate that lenders get charged to borrow money from each other. If the cash rate changes, home loan rates may change too.  Let’s look at how mortgages are funded here.

• The amount you borrow – The more money you owe, the more interest you have to pay back.

• The outstanding loan amount – Interest is calculated on your outstanding loan balance. So, the larger this is, the more interest you get charged.

• The loan term – The longer your loan term, the more interest charges you’ll rack up over time.

Principal and interest vs interest-only loans: what’s the difference?

The principal is the original amount of money you borrow when you take out a home loan.

So, in a principal-and-interest loan, your repayments go towards paying down your principal balance as well as your interest charges. This helps you build equity in your home. 

However, in an interest-only loan, your repayments only pay off the interest charges for the interest-only period (which typically lasts from one to five years). This means your principal balance doesn’t reduce until the interest-only period is over.

How to save on your home loan interest 

Depending on your circumstances and your home loan’s features, you can save on your interest by:

• Using an offset account – An offset account is a transaction account linked to your home loan. You are charged interest only on the difference between your loan’s balance and any money you have in your offset account. So the bigger your balance, the more in interest you can save.

• Making additional repayments – Paying extra on your mortgage reduces your outstanding loan balance. This lowers your interest charges and can cut years off your loan term.

• Refinancing onto a better rate – Australia’s mortgage market is highly competitive and loan products can change frequently. So what was once a great interest rate yesterday may no longer be so today. Refinancing onto a lower rate can save you thousands of dollars over the life of your loan. However, it’s not suitable for every borrower and refinancing does come with some costs.

• Choosing a shorter loan term – The shorter your loan term, the faster you’re mortgage-free and the less interest you’ll end up paying. However, the downside is that your repayments will be higher.