Lots of people come to our seminars and business to learn more about loans and interest. One of the most common questions we get asked is “how is interest calculated?”
It’s an important question to ask, because when you understand the nature of the interest calculation and how it really works it’s easier to work out how you can use it to pay off your mortgage as quickly as possible.
When the banks lend you money, they know they’re getting the original loan amount back. However, they make their money charging interest on the amount you owe. It makes sense.
Unfortunately interest isn’t calculated using the simple interest method. For example, $100,000 at 5%p.a. in simple interest would mean you’d pay $5,000 over a year in interest charges.
By comparison, banks use a compounding interest calculation when working out how much interest to charge on your mortgage. This means the banks calculate the interest due on your outstanding balance at the end of each day and add that amount to the loan, therefore our loan is incrementally increasing each day and then interest is being calculated again.
For the purpose of this example, we’ll say you owe $100,000 and you’re paying 5%p.a. in interest. Your monthly payments over a 30 year loan term are $536.82.
After just one week you’ve already accumulated $95.92 in interest charges. The interest charge will keep adding up on your outstanding balance at the end of every day.
And you haven’t even made a mortgage payment yet to reduce your balance.
At the end of the month, the bank adds up all those interest charges and then they show you one single interest figure on your bank statement. Then you finally make your normal monthly repayment, which drops the balance down a little bit before the whole interest calculation process begins all over again.
So what do can you do to reduce this effect and cut down the amount of interest you pay?
One of the easiest ways to reduce the compounding effect is to increase your payment frequency. If you’re currently making monthly payments on your home loan, think about changing your payment frequency to fortnightly or even weekly.
By making your repayments more frequently you reduce your outstanding balance a little more each week. The bank is only able to charge interest on the amount you owe, so the interest charged is also reduced.
Another way to reduce the amount of interest you pay on your home loan is to make additional payments off your mortgage balance.
For example, you might decide to pay an extra $20 each week on top of your normal repayment amount. The extra payment is paid straight off your loan balance, which means you’ve reduced the amount of interest the bank is able to charge you.
Even if you’re already making voluntary additional repayments off your mortgage, always remember that you can deposit any extra cash you have at any time throughout the year too.
You might get a nice tax refund or a bonus at work, so think about paying some of that money off your mortgage. You’re still reducing your balance, which goes a long way towards reducing your interest charges in the long run.
Another option for reducing the interest you pay on your home loan is to link an offset account to your mortgage. An offset account is just like a regular transaction account or savings account, but it’s linked directly to your mortgage.
When the bank calculates how much interest to charge you, they look at your current mortgage balance and then they deduct the amount of savings you have sitting in your offset account.
For example, if your mortgage balance is $100,000 and you have $10,000 in your offset account, the bank only charges interest on $90,000. The result is that you pay less interest.
Hence as I always say, getting a loan is the first victory but how you structure the loan will win the financial war. Don’t make a rash decision in selecting the right loan type to suit your needs. Instead, make sure you understand how it will work and that it best suits your money personality type.