How interest is calculated on a home loan

How interest is calculated on a home loan

Interest is the backbone of a home loan

Learn how interest is calculated on a home loan

Your interest rate is the backbone of your home loan. It’s the very thing that means the difference between lifelong prosperity or lifelong struggle. Unfortunately many Australian homebuyers end up paying more interest than they otherwise would. This results from a lack of proper understanding how interest is calculated.

We don’t want you to be in that situation. Hence we prepared this blog. It will help you understand how interest is calculated on a home loan.

Interest is a percentage of the total amount of money you owe to your lender. This percentage is arbitrarily set and can either be fixed term or variable.

As the name suggests, ‘fixed’ term interest is a static percentage of your total loan amount outstanding. It remains the same over an agreed upon period of time called a ‘term’. It does not change until the end of that term.

‘Variable’ on the other hand is a dynamic percentage of your total loan amount. It can go up or down according to market fluctuations. For instance, when the Reserve Bank of Australia decides to make changes to the national cash rate.

Each type of interest rate has its pros and cons. We won’t go into those though. The focus of this article is to explain how interest is calculated. For further information on the difference between fixed and variable interest rates, read our previous blog here.

So, interest is calculated daily on your home loan. The bank multiplies the outstanding loan balance at the close of each business day by your interest rate and divides the outcome by the number of days in a calendar year, typically speaking 365.

Let’s look at an example:

Mark and Anna have a mortgage with an outstanding loan balance of $420,000 with an interest rate of 5%. They make a repayment of $4,000 on the 25th of each month.

So $420,000 (amount outstanding) x 0.05 (interest) ÷ 365 (number days in the year) = $57.53 (daily interest)

Say if their repayment date was 25th November 2013, this means that the $57.53 amount will have been factored in from 26th October 2013 to 24rd November 2013 (30 days)

$56.98 is calculated for the one day of 25th November 2013 as a repayment of $4000 was made to the loan reducing the balance of the loan to $416,000 on that day.

The total interest charged for the month would be ($57.53 x 30 days) + 56.98 = $1782.88

Use SwitchMyLoan’s powerful home loan comparison tool below and start comparing how interest rates size up on the different loan products available:

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