How to structure your mortgage to reduce interest

Minimising the interest charged on your home loan can not only save you money on your repayments, but potentially help you pay less interest on your property in total. You may need to think about how your mortgage is structured and set up, as different home loan options may affect how your interest is charged and paid.

Your home loan’s interest charges are the “cost” of borrowing money. Interest is charged on the amount currently owing on your home loan (the mortgage principal) at a rate set by the lender. This rate may be affected by the RBA cash rate and other economic factors. 

Consider making principal and interest repayments

Making interest-only payments on your home loan may seem like the more affordable option. After all, if you’re just paying interest charges, your monthly repayments will be much smaller!

However, your interest-only repayments won’t reduce your mortgage principal, which you’re still obliged to eventually pay back to the lender. The longer you’re making interest-only repayments, the more interest you’ll  likely pay in total on your property.

Choosing principal and interest repayments may cost you more from month to month, but each repayment will pay off a small amount of your mortgage principal. This lets you make slow, steady progress towards reducing your debt.

Try making extra repayments

Some home loans let you make extra repayments on your mortgage. Each extra repayment will directly reduce your mortgage principal, bringing you closer to repaying your loan sooner. This could reduce the interest you’re charged on future repayments and save you money in total interest charges.

Some lenders may limit the number of extra repayments you can make, or how much you can make in extra repayments, or charge fees, while others offer unlimited extra repayments.

If you’re concerned about putting too much of your savings towards your home loan, you could consider a home loan that also offers a redraw facility. This will let you take extra repayments back out of the loan if you need the money again.

Keep in mind that extra repayments likely won’t reduce what you’re charged from month to month, but will affect how much of each repayment is made up of interest. If more of each regular mortgage payment can go towards shrinking your principal, this should accelerate the pace at which your loan is repaid, and potentially save you money in the long run.

See what an offset account could do for you

An offset account is a bank account that’s linked to your home loan. The money you deposit in this account is used to “offset” your mortgage principal when calculating interest charges. For example, if you have a $500,000 mortgage, and have $50,000 saved in an offset account, you’ll be charged interest as if you only owed $450,000. The more money you deposit in your offset account, the more it can offset your principal, and the less interest you may be charged.

Much like extra repayments, an offset account typically won’t reduce your monthly mortgage repayments. Instead, reducing your interest charges should mean each repayment covers a bit more of your mortgage principal. This can help you pay off your loan faster and pay less total interest on your property.

Think about a shorter loan term

Your loan term is the length of time you have available to pay off your mortgage – in Australia, this will typically be between 20 and 30 years, though a few lenders offer longer terms of 35 or 40 years.

Longer loan terms can mean more affordable monthly repayments, as each repayment will consist of a smaller percentage of the total mortgage principal. However, you’ll also be charged interest on more occasions, costing you more in total interest charges over the longer term.

Shorter loan terms may cost more from month to month, as each repayment will cover more of the principal. But as you’ll pay off your property sooner, you’ll likely pay less total interest on your property.

Keep in mind that if you choose to refinance your home loan, switching to a longer loan term could end up costing you more in total, even if your interest rate and monthly repayments are lower, as you’ll be in debt for longer. For example, if you refinanced when you’re 10 years into a 30-year loan, and switch to another 30-year loan, you’ll may be in debt for 40 years or more.

Increase your payment frequency

You may have the choice to make your home loan repayments on a monthly, fortnightly or weekly basis. These options can not only be useful for syncing your repayments to your income cycle, but may help you to pay less interest on your loan.

There are two ways this works:

Firstly, due to the quirks of the Gregorian calendar, in a 12-month year, there are 52 weeks, or 26 fortnights. Because some lenders calculate home loan repayments on the assumption that each month averages around four weeks long, you can effectively make 13 monthly repayments each year rather than 12 by switching to fortnightly or monthly repayments. Over time, this can pay off your loan faster, so you’ll pay less total interest on your mortgage.

Secondly, interest may be charged on your home loan monthly, fortnightly or weekly, but it’s often calculated daily. The more frequently you can make payments that reduce your mortgage principal, the less interest you may be charged over the long run.

You can use a mortgage calculator to work out the effect that switching your repayment frequency could have on your home loan.

Consider a variable rate

Choosing a fixed or variable interest rate may not make a significant difference to your interest charges. Even if you managed to fix your loan at a low rate, your loan will eventually revert to a variable rate, which may have risen higher during your fixed period.

However, variable rate home loans are often more likely to offer flexible mortgage repayment features, such as the option to make extra repayments, redraw extra repayments, or to access an offset account.

Fixed rate loans may not be as flexible, and may also charge break fees if you choose to refinance the loan while still on the fixed term.

Negotiate your rate or refinance your loan

Your home loan isn’t (and shouldn’t be) a “set and forget” financial product. In time, you may be able to approach your lender and negotiate a lower interest rate, which could save you money in repayments and help you pay less interest on your mortgage. Keep in mind that you may need to have built up some equity in the property to be offered some of the lowest home loan interest rates.

If your lender can’t or won’t come to the table, you may be able to switch your mortgage to another lender that offers a lower rate, and/or access to flexible home loan features and benefits.

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