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How is interest calculated on a mortgage?

Learning how interest is calculated helps you understand how mortgage repayments work and how you can reduce them.

There are 2 parts to a mortgage repayment: paying back the money you borrow (the principal) and the interest the lender charges. Unfortunately, this interest adds up to a considerable chunk of money on top of your original loan amount – but the good news is, there are ways to save on interest and own your own home sooner.

Several factors affect your interest repayments, from the Reserve Bank’s Official Cash Rate to the amount you borrow. So let’s take a closer look at how you calculate mortgage interest.

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How is mortgage interest calculated?

Interest on your mortgage is typically calculated daily and then charged to you at the end of each month. Your bank takes the outstanding loan amount at the end of each business day and multiplies it by the interest rate applicable to your loan, then divides that amount by 365 days (or 366 in a leap year).

Home loan interest calculationAssuming you have an outstanding loan amount of $500,000 and an interest rate of 3% p.a., your interest repayment for 1 day would be calculated using the following formula:

($500,000 x 0.03) ÷ 365 = $41.10

Each daily interest charge is added together and then charged to your loan at the end of the month. To determine how much your interest repayments are, input your loan details into our mortgage interest calculator below.

What factors affect the amount of interest you pay?

The following affect how much interest you pay on your mortgage:

  • The mortgage interest rate. This is the rate at which the bank charges you interest on the loan, such as 4% p.a. Some loans feature a reduced interest rate for an introductory period, which then reverts to the standard rate.
  • The Reserve Bank Official Cash Rate (OCR). The interest rate on your mortgage is based on the official cash rate set by the Reserve Bank of New Zealand — Te Pūtea Matua, every 6 weeks. The official cost of borrowing can prompt lenders to charge a higher or lower amount of interest. You can find out how the OCR affects your finances in this guide.
  • The amount you borrow. The greater the sum you borrow from your bank, the more interest you need to repay. For example, 5% of $1 million is always larger than 5% of $500,000.
  • The outstanding loan amount. As you gradually repay the money you borrow, you pay interest on a smaller loan amount and therefore, your interest payments slowly reduce. For example, your interest repayments when you first start repaying a $500,000 loan are much larger than when you pay off half of the principal amount, and interest is only payable on $250,000.
  • The number of days in the month. Most lenders calculate interest on mortgages daily and then charge that interest to you each month. With this in mind, you could pay a smaller amount of interest in February (with 28 days in the month) than you do in March (with 31 days).
  • The loan term. The time you take to repay your mortgage affects the amount of interest you pay, paying your loan over a shorter period minimises your interest repayments.
  • Repayment frequency. Most lenders allow you to make repayments weekly, fortnightly or monthly, so the interest you pay each time varies depending on your repayment schedule. The more frequently you make repayments, the less interest you pay on your mortgage.
  • Whether you have an offset account. Some mortgages come with a linked offset account, which allows you to reduce the amount of interest you pay on your loan. For example, if you borrow $300,000 from the bank but have $50,000 in a linked 100% offset account, you only pay interest on $250,000.

Principal and interest vs interest-only

There’s another factor that can affect your regular mortgage repayment amount: whether you are making principal and interest or interest-only repayments. Principal and interest repayments are the standard way to pay off a mortgage, and they mean that one portion of your repayment goes towards paying off the amount you borrow. Then, another part goes to paying off the interest you owe.

However, some loans are designed to allow you to make interest-only repayments for a specific period. So, for example, if you’re building a new home or are a property investor with an investment mortgage, you can reduce your regular repayment amount.

Example: Susie's mortgage repayments

Susie is borrowing $700,000 to buy a house, and she wants to save as much money on interest repayments as she possibly can. After comparing mortgages with 100% offset accounts, Susie decides to calculate just how much difference a 0.25% p.a. difference in interest rates could make to the total cost.

If Susie can find a loan with an interest rate of 3% p.a. on a 30-year loan term, her monthly principal and interest repayments are $2,951. Thus, the total interest she will end up paying over the life of the mortgage is $362,442.

However, if Susie finds a loan with a marginally lower interest rate of 2.75% p.a., her monthly repayments are $2,858, a saving of $93. In addition, the total interest over the life of the loan will be $467,051.29, that's a total interest saving of $33,480.

* This is a fictional, but realistic, example.

How to save interest on your mortgage

Now that you know a bit more about how interest is calculated, let’s look at the ways you can pay less of it.

  • Get the best rate. Shopping around for a better interest rate can save you thousands of dollars; you may want to consider refinancing with your current lender or switching to a new lender.
  • Look for an offset account. Mortgages with offset accounts allow you to reduce the principal amount you need to pay interest on by literally “offsetting” the loan principal with your savings. It’s a powerful and free way to super-charge your mortgage repayments.
  • Make frequent repayments. The more frequently you make regular loan repayments, the less interest you have to pay. Since interest is calculated daily, even paying weekly or fortnightly instead of monthly can help you make headway.
  • Make extra repayments. The ability to make extra repayments without penalty is a great feature that can work strongly in your favour. The extra repayments off the principal loan amount mean you pay less interest over the life of the loan.
  • Choose a shorter loan term. The longer you take to pay off your mortgage, the more interest you end up paying. Remember, banks calculate interest on your loan amount daily, so choosing a 25-year loan term instead of 30 years can make a big difference.

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