How does home loan interest work?


If you’re new to the world of mortgages, you’re probably wondering what interest is and how it will affect your future home loan repayments. Interest rates have a significant impact on your finances. Paying high-interest rates will not only push up the overall cost of your loan but could extend its lifespan depending on your terms. 

In this article, we’ll dive into home loan interest, how it works, and how you can calculate your principal interest. 

Let’s get to the following commonly asked questions: 

  • What is interest?
  • What is the principal amount on a home loan?
  • How does interest work on a home loan?
  • How is interest calculated on my home loan?
  • How can I lower my principal and interest?
  • What happens if I pay my house off early?

Q1. What is interest?

Interest is the charge incurred when borrowing money from a lender or financial institution. The interest rate used to calculate the amount of interest you’ll pay on top of your loan is typically expressed as an annual percentage rate, known as an APR. 

For instance, if your loan balance is $20,000, you’re paying over a period of time of five years, and your APR is 30 per cent, your months' repayment amount would be $647, and you would repay a total of $38,824. 

Q2. What is the principal amount on a home loan?

When referring to home ownership, the principal amount is the amount owed on a loan or mortgage, sometimes known as the balance. 

Your balance and home loan interest rate are linked since interest is charged as a percentage of your principal.

Note: Some owners choose to pay interest rather than the principal, making an interest-only repayment regularly. This helps to lower the monthly home loan repayment amount over time.

Q3. How does interest work on a home loan?

Borrowers have two interest loan options available to them: fixed home loans and variable home loans. 

A fixed-rate home loan refers to the fix in your interest rate during the introductory mortgage period, usually between two and five years. By fixing your home loan rates, you’ll always know your monthly repayment amount, making it easier to budget. 

A variable interest rate mortgage is a type of home loan where the interest rate is determined by your lender, and your loan repayment changes monthly depending on the official cash rate. 

Q4. How is interest calculated on my home loan?

How your interest rate is calculated depends on whether you have a variable or fixed interest rate mortgage.  

A fixed-rate mortgage is simple to calculate. You simply need to multiply the annual interest rate (your APR) by the outstanding loan amount you borrowed. This is divided over 12 months to give you the monthly interest charge. 

For example: 

Home loan balance: $400,000

Annual interest rate: 5 per cent

Annual interest charge: $20,000 ($400,000 x 0.05)

Monthly interest rate: $1,666

Important: If you’re unsure how interest will affect the amount you have to repay, we recommend using a home loan repayment calculator. Alternatively, you could also use a home loan interest calculator to find out how much interest you’ll pay over the life of the loan.  

Q5. How can I lower my principal and interest?

To lower your principal and interest, you should make additional repayments every month to reduce the amount of interest owed. As the interest is based on the principal balance of your mortgage, the only effective way to lower your balance is to pay off more of your mortgage more regularly. 

Some methods for paying down principal and interest include: 

  • Making additional repayments every month, for example, a fortnightly repayment. Extra repayments on top of your regular monthly payment will allow you to pay off your mortgage much faster. 
  • Refinancing home loans can lower your interest rate and allow you to pay down your principal balance. Comparing home loans will allow you to choose the best possible option. 
  • Depending on your financial situation, you could pay a lump sum to reduce the lifespan of your loan. 

Q6. What happens if I pay my house off early?

Depending on your loan term, paying off your mortgage early could result in an early repayment charge (ERC) which will vary depending on your chosen lender. This often equals around six months of the mortgage’s interest, a percentage of the original home loan value, or the balance still owed. 

However, paying off your home loan early has many benefits. For one, you’ll be debt free and will no longer have to make costly monthly repayments that eat into your budget.

Note: If you’re unsure of your loan terms and how paying early will affect your exit fees, consult with mortgage brokers for a better understanding. 

Summing up

Now you understand everything there is to know about home loan interest, you’re ready to invest your hard-earned money into a property. If you’re unsure about which mortgage is best for you, we would recommend consulting with a mortgage broker or comparing our home loan deals to find your perfect option. 

If you liked this article, you’d love our WeMoney blog. We regularly post financial advice for our viewers. Read our latest article on ‘what is financial supplement debt?’ for up-to-date guidance. 

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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation.

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