Understanding how interest affects your home loan is an important step in the loan process. Even if the interest rate remains relatively low it will still add up to a large portion of your total repayments over the duration of a 25-30 year home loan term.
Many people misunderstand how interest is calculated. For example, when investigating a $100,000 loan at 10% interest, a novice borrower might think the total amount of interest to be paid will be $10,000.
The above calculation would be accurate if the $100,000 (plus $10,000 interest) is paid off in one year, as the interest rate is a yearly cost. However, home loans are a long term commitment where repayments chip away at the amount owing over time.
Putting it in perspective: a typical repayment rate on the $100,000 loan at 10% interest could be $1,000 per month, which would add up to $12,000 paid over one year. In other words, you will have paid $10,000 interest plus $2,000 off the principal amount. This means that in the second year of your repayment schedule you will be paying 10% interest on the remaining $98,000 of your loan.
It’s slow going at first, but with each passing year your $1,000 monthly repayments will more rapidly pay off the lowering interest, plus a greater percentage of the principal amount. In other words, you need to be patient to see results, and the last ten years of your loan repayments will be an exciting time as you watch the amount owing quickly disappear.
Reducing interest on your loan
There are various strategies that can help to pay the loan off faster and reduce the overall amount of interest you pay.
Make fortnightly repayments: If you halve your monthly repayment and pay that amount fortnightly you will be making two extra payments every year. This will more speedily reduce the amount you owe and you’ll also pay less interest over the duration of your loan. If you use the above strategy on a 30 year $250,000 loan at 7% interest per annum, you will save around $85,000 in interest and the loan will be paid off more than 6 years ahead of schedule.
Increase your regular repayments: If you have money to spare, this method will achieve similar results to the above equation. By paying around $50 extra per fortnight on your $250,000 loan you will have it paid off almost 5 years ahead of schedule.
Shorten the duration of your loan: Using the same $250,000 loan example and switching from a 30-year term to a 25-year term will save you close to $70,000 in interest costs.
Make lump sum payments: If your financial position improves there may be ready cash that can be used to pay off the loan. Even $15,000 paid toward the $250,000 loan will reduce the loan duration by close to 5 years and save you more than $20,000 interest costs. Always check the conditions of your contract though, as there could be a fee attached to lump sum payments if you are on a fixed rate payment schedule.
Another way to save is by keeping your monthly repayments the same even if the interest rate drops. Avoid the temptation to lower your monthly or fortnightly repayments and you will reduce the principal faster while also saving on overall interest costs.
Fixed interest rate versus variable interest rate
By far the two most common type of home loan contracts involve either fixed or variable interest rates. They both have individual advantages (and disadvantages) and there may be times during your loan term that you switch between the two.
Variable rates: Your variable interest rate will go up or down according to overriding financial conditions. Your lender has the right to raise or lower the variable rate at any time. On the plus side, you have the option to make extra payments without incurring any fee.
Fixed rates: Your fixed interest rate will be locked in for a period that is typically between one and five years. You have the benefit of knowing exactly how much your payments will be during this time. On the downside, you won’t benefit if interest rates fall, and you may not be able to make extra repayments on your loan while you are locked into the fixed rate.