How is interest calculated on a home loan?
Although it might sound quite a complex process it's actually not that difficult. If you're interested in paying off your home loan quicker and saving some money then this is an important calculation to understand (I'll explain more below).
First things first
To figure out how much interest you pay each month, you need to know the following:
Your interest rate
How it's calculated
Interest on your home loan is generally calculated daily on the balance of your loan and then charged to you at the end of each month or payment cycle (weekly, fortnightly etc.). Your bank will take the loan balance at the end of each day and multiply it by the interest rate that applies to your loan, then divide that amount by 365 days (or 366 in a leap year). Let's give you an example:
Loan balance = $450,000
Current annual interest rate = 2.5%
Days in the year = 365
Daily interest rate = (450,000 x (2.5 / 100)) / 365 = $30.82
At the end of the month (or your payment cycle) they add all these figures together which makes up the amount of interest you see on your statements
So how can knowing this save you money?
Most people have a Principal & Interest loan which means you are paying down your loan over the loan term, so at the end of the period (say 25 years) you don't owe any further money and you own your home.
By knowing that the bank calculates the interest rate daily the more frequent your repayments the less interest you have to pay as the interest amount will be calculated daily on the lower balance. See table below to see how the interest amount drops after each monthly payment:
Now imaging if you paid the balance down quicker and more frequently, this would greatly affect the amount of interest you have to pay back.
Here's one solution on how you can easily achieve it; Most people have heard of an offset account but are not sure how they work or what they do. Quite simply the money you have in your offset account is reduced from the loan balance you owe which means you pay less interest. For example:
Let's say you have a $450,000 loan at 2.5% over 25 years as above on monthly repayments, but this time you have $20,000 (your rainy day fund) sat in your offset account, over 25 years this would save you $21,333.77 in interest repayments which reduces your loan term by 1 year 11 months!
This could mean you are able to retire early and you've not had to do much over the 25 years.
There are some catches to using an offset account and most lenders charge an annual fee of around $395 to try and make up for the loss they are making.
Don't forget the bigger your offset account the more you will save!
Another amazing trick is to make fortnightly repayments, but we will go through this in more detail as to the extra benefits in our next blog so keep tuned.
If you would like to find out more information on any of the above or would like to see how we can help you with your mortgage Contact us.
WARNING: The contents of this communication are not designed to replace credit advice. We have not taken into account your needs, objectives or financial situation. The comparison rate is true only for the examples given and may not include all fees and charges. Different terms, fees or other loan amounts may result in a different comparison rate. The comparison rate is calculated on a $750,000 secured loan over a 25 year term at 60% LVR.