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How Is Home Loan Interest Calculated in Australia?

Taking out a home loan is a major financial decision that most Australians will make at some point in their lives. With housing prices being high, especially in major cities like Sydney and Melbourne, the vast majority of homebuyers need to take out a mortgage to finance their property purchase.

A key thing to understand when taking out a home loan is how the interest is calculated by your lender. This will have a major impact on your total repayments over the life of the loan. Below is an overview of how home loan interest works in Australia.

Types of Interest Rates

The first thing to know is the two main types of interest rates that apply to home loans:

  • Variable rate – With a variable rate loan, the interest rate can move up and down over time. The rate is usually tied to the Reserve Bank of Australia’s (RBA) cash rate target, so if the RBA raises or lowers rates, then the variable rate will also change. Variable rate loans are more flexible as you can pay extra off the loan or make lump sum repayments when rates are lower. However, the risk is rates could go up increasing your repayments.
  • Fixed rate – A fixed rate loan locks in a set interest rate for an agreed period, usually 1 to 5 years. Your repayments stay the same during the fixed period, providing certainty. However, if rates fall you will be stuck on a higher rate until the fixed term ends. Breaking a fixed loan usually involves paying break fees.

How Interest is Charged

With both variable and fixed-rate mortgages, interest is charged on the outstanding loan balance you owe. Your loan balance starts high when you first draw down the mortgage. But over time as you make repayments, the balance gets paid down.

Interest is calculated daily based on your remaining loan balance. So as your balance reduces, the interest you pay also goes down over the life of the loan. Lenders use a 365 days per year calculation to charge interest.

This is beneficial compared to a calendar month which can vary from 28 to 31 days. By using 365 days/year, your daily interest charge is lower than if a lender based it on calendar months.

Introductory Rates

It’s common for lenders to offer a lower introductory interest rate as a home loan promotion. This discounted variable rate might be 1-2% below the standard variable rate and last for 1-2 years.

While intro rates appear attractive and reduce your initial repayments, you need to prepare for higher rates once the intro period ends. Make sure you factor this into any affordability calculations. Also be aware many lenders charge expensive break fees if you switch loans during an intro rate period.

Payment Frequency

Another factor is how often you need to make home loan repayments. Most lenders will require you to make payments on a monthly basis. However, some lenders may also give you options like weekly or fortnightly payments.

Paying more frequently than monthly helps reduce your interest bill faster by cutting down the loan balance quicker. This can save thousands in interest over the full mortgage term.

How the RBA Cash Rate Affects Home Loans

Mortgage Approved

As mentioned above, standard variable mortgage rates tend to follow the RBA’s movements of the official cash rate target. This is the interest rate the RBA charges banks for overnight lending between financial institutions.

When the RBA raises or cuts the cash rate at one of its monthly board meetings, lenders will typically pass on the changes to borrowers with variable-rate home loans. Fixed-rate loans are not impacted unless they are being renewed after the fixed term expires.

So if the RBA implements 0.25% rate rises over several months, then the variable rate on your mortgage will also gradually go up by a similar amount. Staying informed about RBA announcements and actions will help you understand how your mortgage interest may change.

Other Factors Impacting Interest Rates

While the RBA cash rate is a primary driver, there are other factors lenders consider when setting and adjusting their home loan interest rates including:

  • Funding costs – How much it costs a lender to source the funds in wholesale markets to provide home loans. If these costs go up, some of the increase may get passed onto borrowers.
  • Profit margins – Lenders may widen or narrow their margins on home loans to achieve profit targets or remain competitive. Wider margins mean higher rates for borrowers.
  • Government regulations and policies – These can impact how much interest lenders can charge. For example, policies like the bank levy may be passed onto customers.
  • Competitor interest rates – To attract new borrowers, lenders monitor what competitors are charging and may adjust their own rates.

Features Impacting Interest Costs

When choosing a mortgage, the interest rate is not the only thing that affects your total interest bill. Other features that impact total interest costs include:

  • Fees – Upfront fees to establish a loan and ongoing monthly fees can both increase interest costs. Try to avoid lenders with excessive fees.
  • Extra repayments – Most lenders allow extra lump sum repayments which helps pay your mortgage down faster reducing interest. Consider a lender that allows unlimited extra repayments free of charge.
  • Offset account – This type of transaction account is linked to your mortgage allowing the balances to offset. This way your savings work to reduce interest costs. Make sure any offset features are fee free.
  • Early repayment – Many lenders charge break fees if you repay your loan early, especially if you switch lenders. Consider whether early repayment fees apply and factor this into choosing a lender.

Maximising Interest Savings

Home Loan Calculation

To help minimise interest costs on your home loan, some tactics include:

  • Making extra repayments when you can to pay down your loan faster
  • Choosing lower-rate lenders and negotiating hard for discounts
  • Splitting your loan to part variable and part fixed to get the best of both
  • Staying informed about rate changes and incentives you can use to lower costs
  • Tracking your loan balance and performance vs your repayment schedule
  • Avoiding expensive bank fees that add to your loan balance
  • Using an offset account effectively to lower interest

By understanding clearly how home loan interest works in Australia and taking steps to reduce your costs, you can save substantially over the life of your mortgage. This frees up funds for other goals you may have like investment, travel or education.

Need advice on a home loan? Get in touch with Finfix Broker Group today.

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