Interest charges are one of the most significant costs to consider when applying for a home loan. But how much could a home loan ultimately cost, and are there any ways to lower the total interest you’ll pay?
The basics of home loan interest charges
When you apply for a mortgage, you agree to repay your lender the money you borrowed to buy your home (the mortgage principal), plus an extra charge called “interest”. This interest charge is calculated as a percentage of your remaining mortgage principal – the more money you owe, and the higher your interest rate, the more you could ultimately pay for your property over time.
Most Australian home loans are structured to be repaid in regular instalments over a long loan term, often lasting 20 to 30 years. Each repayment you make will pay off a small amount of the remaining loan principal, and cover the cost of the lender’s interest charge. At the start of a home loan, the majority of each repayment is likely to be made up of interest charges, but this ratio is likely to shift over time as you slowly reduce your mortgage principal and are charged less interest on each repayment.
Imagine you’ve successfully applied for a $1 million home loan, to be repaid in monthly principal and interest instalments over a 30 year term, at an interest rate of 3.54%.
This would mean that after making 360 monthly repayments of $4513, your mortgage principal would be fully paid off and you would own the home outright.
You would pay $624,608 in interest payments, meaning your million-dollar property would ultimately cost you $1,624,608, plus the deposit, stamp duty, and other fees and charges.
Repayment schedule for the first 6 months
Source: RateCity Mortgage Calculator. Calculations are estimates only.
It’s important to remember that these calculations assume that the interest rate charged on your home loan will stay the same over the full term of your mortgage – something that’s unlikely to occur in real life. While it’s possible to fix your interest rate for up to five years, most home loans in Australia eventually revert to a variable interest rate, which a lender may choose to raise or lower depending on a variety of economic factors, from the cost of overseas funding to the national cash rate set by the Reserve Bank of Australia (RBA). This could increase the interest you’ll pay on your mortgage if rates rise, but you may pay less interest if variable rates fall.
How can you save on interest charges?
Refinance to a lower interest rate
If you hold some equity in your property, you may be in a position where you can look into refinancing from one mortgage lender to another, hopefully one that offers a lower interest rate, lower fees, and home loan features and benefits that more closely match your personal goals and financial situation.
Switching to a low-rate home loan could reduce the cost of your monthly repayments, though if you can afford to keep making your original repayments, the extra money would go straight towards reducing your mortgage principal, helping to lower your interest costs over time.
Speaking of which…
Make extra repayments
One of the simplest ways to pay less interest on your home loan over the long term is to make extra repayments towards paying off your mortgage principal.
Whether it’s regularly putting a little bit extra towards your mortgage with each repayment, or whacking a lump sum onto your loan when you can afford it (such as when you get a tax refund, for example), every time you reduce your mortgage principal, you’ll be one step closer to potentially paying off your property early, and save that little bit more on interest charges.
If you’re concerned about locking up your savings in your mortgage, you may be able to use a redraw facility to access your extra repayments again in case of a financial emergency. Keep in mind that not every lender offers a redraw facility, and some may charge fees or limit how the facility can be used.
Use an offset account
An alternative to putting your savings into your home loan could be to deposit some of this money into an offset account – a bank account linked to your home loan, where you can easily deposit, withdraw and transfer money as required. Money deposited in this account is used to “offset” your mortgage principal when calculating your interest charges. For example, if you had a $400,000 mortgage principal, and $30,000 saved in your offset account, you’d be charged interest as if you only owed $370,000 on your home loan.
Keep in mind that home loans with offset accounts may charge higher interest rates and fees than more basic “no-frills” home loans. You may want to check if the average balance you plan to hold in your offset account will be able to make a meaningful difference to your potential interest savings.
Increase repayment frequency
Because many lenders calculate interest daily but charge it monthly, the more regularly you can lower your mortgage principal, the less interest you may be charged. This is one reason it may be worth considering switching from monthly to fortnightly or weekly repayments. Another is that making 26 fortnightly repayments is the equivalent of making 13 monthly repayments in a 12 month year, again paying off your property that little bit faster.
Shorten your loan term
Switching your home loan from a long loan term to a shorter term (30 years to 20 years, for example) could make a big difference to your mortgage costs, both from month to month and over the lifetime of the loan.
A shorter loan term means your monthly repayments will cost more, as you’ll be paying back the principal in a smaller number of repayments. However, because you’ll be paying off your property sooner, you may pay less in total interest charges.
For example, as mentioned previously, a $1 million mortgage repaid in monthly principal and interest instalments over a 30-year term at a rate of 3.54 per cent would ultimately cost you over $1.6 million.
Shortening the loan term to 20 years would mean each monthly repayment costs $5820, but you’d pay just $396,842 in interest, for a total loan cost of $1,396,841 – a saving of over $200,000.