Learn more about how interest is calculated and how you can pay less

Interest is one of the inevitable costs of taking out a loan. And it’s important to understand because your interest rate will also make a significant difference to how much money you pay in total over the life of your mortgage. But just because it’s inevitable (and important!) doesn’t mean it has to be intolerable.

So let’s learn about interest, how its calculated, how much you’ll pay over the life of the loan and how you can pay less.

All About Interest

When it comes to understanding interest, we need to understand three important terms:

1. Principal: The principal is simply the loan amount. Essentially, the sum of money that you will borrow from your lender, before any interest is applied.
2. Interest rate: The interest is the amount charged to you by the lender for borrowing the principal. It’s generally a monthly percentage rate.
3. Term of loan: The term of loan is the number of years you will take to pay the principal back to the lender.

The interaction of these three terms tells us how interest is calculated and how much you’ll pay over the life of your loan.

How is the interest rate determined?

The interest you pay on your loans is determined by your interest rate. The Reserve Bank controls Australia’s official ‘cash rate’, which it defined as ‘the interest rate on overnight loans in the money market’. Lenders take the cash rate and then use this as a jumping off point for determining their own interest rates on their various loans. However, when the cash rate rises, the lenders rates will generally follow suit.

A spate of recent rises over the past few years year has meant we are experiencing high interest rates in Australia right now.

How is interest calculated?

In very simple terms, the formula for calculating loan interest is:

Interest Rate x Principal x Term

This formula will determine the amount of interest you will pay. So, if you have a $500,000 loan with an interest rate of 5% over a 30 year term, you can expect to pay $466,279 in interest over the life of the loan (if you make monthly repayments). If you raise the interest rate to 6.24%, that interest rate rises to $607,121.

Different lenders may calculate your monthly interest charges differently. Generally, interest is calculated daily but charged monthly, and is calculated on your loan balance as your progress through the life of your loan. This means that as your loan balance decreases over time, so too will the amount of monthly interest you pay.

How much interest would you pay on a 500,000 home loan?

Principal	Interest rate	Term	Total interest
$500,000	5.74% (BankFirst)	30 years	$549,288
$500,000	5.89% (Firefighters Mutual Bank)	30 years	$566,495
$500,000	6.09% (BOQ)	30 years	$589,629

Variable versus fixed interest rates

Of course, if you’ve chosen a variable interest rate, you will find that your loan’s interest rate will rise or fall depending on changes in the cash rate. On the other hand, a fixed rate might start out at a higher rate, but over the fixed term period you will also have confidence in your monthly repayments.

How to decrease your interest paid

The amount of interest you’ll pay over the life of your home loan is significant. So it’s worth finding ways to decrease it if possible.

Look for low interest rates

It pays to do your homework on interest rates. As you can see in the above examples, a small difference in the interest rate can make a large difference over the term of your loan. Make sure you shop around for the best rate to suit your needs.

Consulting a broker team like Lending Loop can help, as we compare loans from more than 40 different lenders.

Opt for a principal and interest loan, if you can

There is definitely a time and a place for interest-only loans. Choosing an interest-only home loan may help to reduce your payments in the short term, but you will inevitably pay more over the long run. If you are trying to reduce your interest payments, try to pay off the principal and interest simultaneously.

Consider the pros and cons of fixed vs variable

It’s all about timing with this one. In a fixed rate loan, your interest rate will be locked in at a set rate for a certain amount of time, while in a variable rate loan, your interest rate can fluctuate. If your lender offers a split option, you can choose to fix part of the home loan and leave the rest as variable.

If only we had a crystal ball to see the interest rates of the future and determine which type of loan would be the smartest move. But speaking to a financial advisor for expert financial advice is a great second choice.

Increase repayment frequency

Now this one may sound confusing, but it is a clever little tip to help yourself pay the balance down faster without it hurting the hip pocket too much. If you increase the frequency of your repayments, for example from monthly to fortnightly, you will end up paying off the principal faster as there are 26 fortnights in a year and 12 months.

Just be sure to check how your chosen lender calculates repayment frequency before selecting this option.

Make extra repayments

Of course making extra repayments will help to lower the balance of your home loan, thereby reducing the amount of interest you will need to pay. In addition, if your loan has a redraw facility, you will also be able to access the extra repayments should you need to.

Consider an offset account feature

An offset account can also help you to pay less interest, as the amount of money you have in this everyday transaction account will be deducted from your loan balance when calculating your interest.

Refinance if necessary

If you can find a lower interest rate elsewhere on a comparable product, it may be time to switch home loans or even lenders. While fees may apply to refinance, you may still be better off in the long run. It may even be as simple as approaching your current lender with your research and asking for a better interest rate on your existing product.

Find a trustworthy team to guide you

If you would like some experienced professionals in your corner to help you make the best choices to reduce your interest, please get in touch with the team at Lending Loop, and let’s see how we can help! We can assess your current situation and see which is the right path for you.