How home loan interest rates work

Buying a home or investment property will usually require you to borrow money from a lender. The amount the lender lends you is called the principal while the interest rate is the cost for borrowing the principal amount.

Most loan repayments are made up of two parts - principal repayments and interest repayments. The size of your loan repayment will be determined by the principal loan amount, the interest rate and the term of the loan. However, it's the interest rate that has the biggest impact on how your repayments may change over the life of your loan and the overall amount you pay back on your home loan. So it's important to understand how interest rates work and how they can affect your loan repayments and the cost of your loan.

How interest is calculated in a home loan?

A home loan’s interest rate is the cost of borrowing money from a bank. The interest rate on a home loan is usually expressed in percentage terms, called the Annual Percentage Rate (APR). Your lender will take the amount of your loan and multiply it by your interest rate. They will then divide that amount by 365 days (366 days in a leap year). 

So, for example, if you have a loan or a principal amount of $600,000, and your interest rate is at 4%. Your interest repayment for one day would be calculated using this formula: ($600,000 x 0.04) ÷ 365=$65.73. If you want to know approximately how much you pay in interest in a month, you just need to change the time into a monthly rate by dividing it by 12 (and not dividing by 365).

The interest cost of your loan is added up each month, generally calculated daily, and the monthly cost is added to your outstanding loan balance every month. Interest is charged from the day your loan settles, so the settlement date will determine your ‘due date’ (the date the interest is charged and added to your loan every month). For example, if you settled on 10 April, your first interest ‘due date’ would be 10 May and the 10^th day of the month thereafter.

What key factors can affect interest rates?

The Cash Rate

Interest rates can change as a result of changes in the Reserve Bank's official Cash Rate. The Cash Rate is a target set by the RBA and reflects the overnight money market interest rate (see The Reserve Bank and Cash Rates for more information).

Inflation

There is a direct relationship between inflation and interest rates. When inflation increases, there will be upward pressure on interest rates. When inflation decreases, there will be downward pressure on interest rates.

Market Indicators

The financial market observes and responds to domestic and international data and events in an ongoing capacity. The market’s response is known as market volatility. The level of market volatility can impact interest rates in terms of upward and downward movements. Indicators of potential and actual interest rate changes can include (but are not limited to) world and central banks commentary and cash rate changes, inflation levels, unemployment levels, economic performance figures including consumer demand for goods. The markets also observe and respond to political events (eg changes in Government) and world events such as war.

The purpose of the loan

For example, whether it's owner occupied vs investment. As the name suggests, an owner occupied loan is a loan you obtain for the purpose of buying or refinancing a home you live in. An investment property loan is taken out to buy or refinance a property you intend to rent out. The key difference between the two is the interest rate. Investment loans often have higher interest rates than owner occupied.

The Interest Rate Type

There are two types of interest rate types for home loans - variable and fixed. If you have a fixed rate loan, your interest rate is locked-in for a period of time which means your repayments stay the same during the fixed period (e.g. 1 to 5 years). In comparison, a variable rate loan's interest rate cill change over the term of the loan which means the repayments will fluctuate.

The Loan Repayment Type

You can choose to repay your loan in one of two ways - principal and interest or interest-only. If you choose a principal and interest loan, you will repay some principal each month as well as the interest. This means your loan balance will reduce with each loan repayment. Or you can choose to make interest-only repayments for a period of time (typically one to five years). Interest only loan interest rates are typically higher than those for owner occupied loans. As only the interest is paid (no principal payment), the balance of your loan stays the same and doesn’t reduce during the interest only period. While this option has lower repayments during the interest only period, your repayments will increase once the interest-only term ends, and you could end up paying more interest over the life of your loan compared to that of a principal & interest loan.

How much can you borrow?

You may have heard about something called a Loan to Value Ratio (LVR), the amount you can borrow is limited by your ability to make repayments (i.e. your 'serviceability') as well as the value of the property you are financing (which will secure the loan).

Your loan ‘serviceability’ can be influenced by your factors like your income, employment, living expenses, existing liabilities (e.g. credit cards, loans, HECS debt),  how many children you have etc. How much can I borrow?

Tips to reduce the interest you pay on your home loan

Make extra repayments

This helps reduce the overall cost of your home loan as the more frequently you make repayments, the less total interest you will pay. Note that the type of loan you have may limit the extra repayments you can make - fixed rate loans typically have a cap, while you can make unlimited extra repayments on variable rate loans.

Add an offset

Offset account is a feature of a home loan account where you can deposit your income eg salary, rental income etc. When calculating your home loan interest, the interest is calculated on the balance of your loan. As your home loan balance is reduced by the amount you have in your offset account - this means you'll pay less interest on your home loan.

Shop around

Comparing home loan interest rates and features will help you find the home loan with the rates and features that best suit your needs and budget.

^* You have to be a Qantas Frequent Flyer member to apply for the Qantas Home Loan. This information has been prepared without considering your objectives, financial situation or needs. You should consider your circumstances before acting on this information.