How does a bank charge interest on your home loan?

Interest rates are one of the most significant costs associated with a home loan, so you may be curious exactly how interest is calculated and charged to you.

Luckily, there are Mortgage Repayment Calculators available to do the maths for you. But some homeowners and would-be buyers may want to know exactly how a lender calculates home loan interest, and how to do this maths yourself.

How to calculate home loan interest charges

Home loan interest is calculated daily by multiplying your loan balance with your interest rate (in decimal form) and dividing this by 365 (366 in a leap year).

Your monthly interest charges are calculated by multiplying your daily interest amount with the number of days in said month. The payable amount of interest may change depending on your interest rate and the number of days in the month. So, if interest rates were to rise or if it were a longer month, your repayments would be higher that month.

For example, on a $500,000 home loan with an interest rate of 2.5%, you would calculate the daily rate of interest using the following formula:

• ($500,000 x 0.025) ÷ 365 =$34.25

Then to determine your weekly, fortnightly, or monthly interest charges, simply multiply the above figure by the number of days in this payment cycle.

• Weekly repayments: $34.25 x 7 = $239.73
• Fortnightly repayments: $34.25 x 14 = $479.45
• Monthly repayments: $34.25 x 30 = $1,027.40

Unless you are making interest-only repayments, you will also be charged for the principal owing on your mortgage. The above calculations are simply just the interest charges for your repayments over a specific time frame.

How to reduce the amount of interest charged on your mortgage

As mentioned above, interest is one of the most significant costs you’ll face when repaying a mortgage. Depending on your financial situation and budget, it may be worth considering strategies you can keep your interest charges and mortgage repayments down, including:

• Offset account

An offset account is a home loan feature offered by some lenders, typically for variable rate home loans. It acts as a linked transaction account and by depositing funds into your offset account, this helps to “offset” or reduce the amount you pay in interest.

For example, on the same $500,000 home loan, if the homeowner deposited $30,000 into their offset account, then their interest charges would be calculated as if the mortgage were only $470,000.

This would make the home loan calculations:

• ($470,000 x 0.025) ÷ 365 =$32.19
• New monthly interest charge = $965.73
• Previous monthly interest charge = $1,027.40

• Ask for a rate cut

If you’ve been repaying your home loan for a while, you may want to hop online and see what interest rates your lender is offering new customers. Chances are they will be much lower than what you’re paying as lenders typically offer lower rates to entice new customers onto their books.

The latest data from the Reserve Bank of Australia at the time of writing shows that for the average owner-occupier variable home loan customer, new customers are paying rates of 2.52% and existing customers are paying 2.94%. This means new customers are earning a discount of 42 basis points just for being new customers.

To help reduce your interest rate, it may be worth picking up the phone and simply asking your lender for a better rate. Mention you’ve seen that they offer lower rates for new customers. You’d be surprised at what you may get if you just ask for it.

• Refinance to a lower rate

If you’ve built up a bit of equity in your mortgage and are unhappy with your current interest rate, you could consider doing some research and refinancing your home loan to a lower rate lender.

Use comparison tools, like RateCity’s low-rate home loans table, to filter down and view competitive options that may better suit your financial situation. You can even use this research as ammunition if you call up your lender and try to negotiate a better home loan rate. If they won’t budge, it may be worth calculating the switching costs and determining if refinancing to a lower rate may be the best move.

Compare home loans in Australia