How are home loan interest rates calculated?

12th October 2020 - Freya Cormack

How are home loan interest rates calculated

Have you ever wondered how your interest rate is calculated? Well, we’re here to explain. Interest rates are a top concern for any current or prospective homeowner. A high interest rate can add to your financial burden and increase your repayments substantially. 

On the other hand, a lower interest rate can guarantee you big savings. Your bank doesn’t just charge interest rates randomly, they have their own costs to cover and all banks are guided by the same thing: the cash rate.

What is the cash rate?

Banks borrow from each other through unsecured overnight loans and the cash rate is their interest rate. It is determined by the Reserve Bank of Australia (RBA) at 2:30pm on the first Tuesday of every month, except for January. 

The interest rate your bank charges will never directly correspond to the cash rate, as interest is how they profit. It will always be higher, but when there are cash rate drops, banks generally pass the rate cuts on. 

Borrowers with variable interest rates should watch the cash rate, as a rising cash rate can result in rising interest rates. If you have a fixed rate home loan, your interest rate remains firm during the fixed period, no matter how the cash rate changes. 

What should I do if my bank won’t pass on low interest rates?

If the cash rate has dropped and your bank hasn’t passed on interest rate cuts to its customers, it may be time to reassess your home loan. When banks don’t pass on rate cuts, they do it to increase their profits since the margin between the cash rate and their customers’ interest rates will be wider than it should be. 

Homeowners with a fixed interest rate don’t have many options. The nature of a fixed rate home loan is that your interest rate will not change within the fixed period. Your options are different if you have a variable interest rate. 

Variable rate homeowners can try to get a better interest rate by:

  • Contacting your bank: sometimes banks need a little pressure to reduce your interest rate. Make sure that you are not paying more in interest than new customers. If you have a solid repayment history and at least 20% equity, your bank may be willing to offer you a lower interest rate if they are able to. 
  • Compare interest rates: don’t just limit yourself to your existing bank. Many banks are more generous with applying rate cuts when the cash rate drops than others. You can easily search and compare interest rates online. 
  • Refinance: if you’ve found better home loan deals and interest rates elsewhere, it may be time to refinance. By switching home loans and getting a lower interest rate, you could save thousands of dollars. 

Before considering refinancing, make sure that any costs involved don’t outweigh the benefits of switching. Homeowners with fixed interest mortgages should be aware that break costs may be charged to borrowers refinancing before their fixed term is over. 

Consider using a broker to negotiate with banks on your behalf. It’s likely that they’ll be able to get you a better deal than if you were to be the one negotiating. Brokers don’t charge fees to borrowers as they earn money through the banks themselves. 

Related: 3 reasons to switch mortgage lenders when you refinance

How is interest calculated on my home loan?

Interest is charged as a percentage of your loan balance and it is calculated every day. How it works is that your bank will multiply your outstanding loan amount by your interest rate. They will then divide this by 365 and that number will be your daily interest charged. 

For example, if you have a loan balance of $200,000 with a 4% interest rate, you can calculate your daily interest charged using this formula:

($200,000 x 0.4) ÷ 365 = $27.39

Even though your interest is calculated daily, you’ll pay it along with your principal repayment monthly, fortnightly or weekly — depending on how your loan repayment is structured. 

Always remember that the higher your interest rate, the more you’ll pay over the course of your home loan. Where possible try to secure as low an interest rate as possible. However, everyone has special circumstances that influence how they can repay their loan. So, don’t just focus on the interest rate. Look at the loan package as a whole. 

If you have certain loan features offsetting your interest, you may be charged less. 

How to save on interest

Apart from lowering your interest rate, there are other ways to reduce how much interest you are charged. 

Certain loan features, such as offset accounts and redraw facilities are designed to help borrowers with extra savings pay less interest. An offset account is a kind of savings account linked with your loan balance. Any funds in this account offset how much interest you are charged. 

For example, if you have a $200,000 loan balance, with $30,000 in your offset account, you only pay interest on $170,000 of your loan. You also have easy access to the money in your offset account when you need it. 

Similarly, any funds in your redraw facility offset your interest. The funds in your redraw facility come from extra repayments you make on your home loan. You can also access these funds, but there are usually withdrawal fees and wait times. 

Another strategy is to up your repayment frequency. When you make more frequent repayments, you’ll pay less interest overall. If you switch from making monthly repayments to making fortnightly ones, you can save in interest and pay off more of your loan. 

For example, if your monthly repayments were $4,000 and you change to $2,000 fortnightly repayments, you would save on interest and pay off an additional $4,000. This is because you’ll end up making the equivalent of one extra monthly repayment.

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The information in this post is general in nature and should not be considered personal or financial advice. You should always seek professional advice or assistance before making any financial decisions.

Rate my Bank is powered by Lendi and Lendi is the trading name of Lendi Pty Ltd (ACN 611 161 856, Credit Representative 518849), a related body corporate of Auscred Services Pty Ltd (ACN 164 638 171, Australian Credit Licence 442372). We will never sell your email address to any third party or send you nasty spam, promise.

*WARNING: This comparison rate is true only for the example given and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate. The comparison rates are based on a loan amount of $150,000 over a loan term of 25 years. Fees and charges apply. All applications are subject to assessment and lender approval. Quoted rate applies only to PAYG loans with LVR of 80% or less with security in non-remote areas. All applications are subject to assessment and lender approval.

^The estimated average future interest savings is calculated as at 15 April 2020 based on Lendi assisting customers into new loans with an average interest rate reduction of 0.89% for the 11 months prior, and assuming a median loan term of 26 years on both the old and new loan and all monthly principal and interest repayments will be made on time. Any future savings figures are estimated averages only, and do not take into account any product features or fees (including refinancing or break costs). Your savings will be different.