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Interest rates: What are they and how do they work?
Interest rates: What are they and how do they work?
Written by
Tina Sendin
Edited by
Ellie Garran
Reviewed by
Sam HymanCompare home loans the easy way
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- What are home loan interest rates?
- Why do interest rates change?
- What are the different types of interest rates?
- How have interest rates changed over time?
- What affects my home loan interest rates?
- How is interest calculated on a home loan?
- How can I reduce my interest?
- Where can I compare home loans?
Long story short
The RBA cash rate drives what banks charge you
When the RBA raises or lowers the cash rate, lenders adjust home loan interest rates accordingly.
Cash rates went down in 2025 before climbing back up in early 2026
In the 2025–26 financial year, the RBA cut the cash rate once before hiking it up 3 times, with the average cash rate for this period sitting just under 4%.
You can reduce your interest payments by paying more often, shortening your loan length, or using an offset account
Negotiating with your lender and comparing interest rates could also help you save.
What are home loan interest rates?
Interest rates are the percentage your lender charges on the money you’ve borrowed (the principal). Most interest rates you see are a percentage per annum (p.a.), which you pay back along with your regular monthly (or fortnightly, or weekly) repayments.
The amount of interest you pay changes over time because it’s typically calculated on your remaining loan balance. For example, if you have a principal and interest loan with a balance of $500,000 and an interest rate of 6% p.a., interest is initially calculated on the full $500,000.
As you make repayments and reduce your loan balance to, say, $400,000, interest is then calculated on this lower balance. This means the interest portion of your repayments gradually decreases over time, while more of each repayment goes towards paying down the principal.
Why do interest rates change?
Interest rates change to help keep the economy on track – mainly by managing inflation and employment. The Reserve Bank of Australia (RBA) tweaks the cash rate to influence how much people borrow and spend. They’ll lift rates to cool spending down if the economy is running hot. Or if the economy’s slowing, they’ll cut rates to give it a boost.
Interest rates are one of the main tools for monetary policy that the RBA uses to steer the economy. By moving rates up or down, it can influence things like inflation, jobs and overall growth. When rates go up, borrowing, spending and investing tend to slow down. When rates drop, it usually encourages people and businesses to spend and invest more.
It makes sense, really. The RBA sets the national cash rate, which is the interest rate that banks pay to borrow from and lend to each other. Lenders use the cash rate to decide what interest rates they’ll set for their own products, including home loans, personal loans and savings accounts.
Here’s what it means for borrowers. A low interest rate means it’s cheaper to borrow money, and you don’t earn much by saving it. A high interest rate means it’s expensive to borrow money and you earn more on your savings accounts, which means people are less likely to spend money.
What are the different types of interest rates?
The main different types of interest rates are variable (changing depending on market conditions), fixed (frozen for a set time) and split (a mix of both). They all impact your repayments in different ways. In some cases, a lender might also offer honeymoon rates, which are discounted interest rates for an introductory period.
Variable interest rates
Variable interest rates fluctuate along with market conditions or RBA decisions, which means your repayments can go up or down. If the cost of lending goes up, the interest rate will too.
Standard variable-rate home loans tend to come with other features to make them more flexible and attractive – such as unlimited additional repayments – although these can carry a slightly higher interest rate. Basic variable loans usually have more competitive rates, but may lack features that a standard variable loan will typically have.
Fixed interest rates
Fixed interest rates stay steady for the period of the fixed term regardless of market fluctuations. They usually stay fixed for between one and 5 years, although some lenders may offer longer fixed-rate terms.
Because of this, fixed-rate home loans offer stability and predictability when it comes to repayments – although when rates go down, you might end up shelling out more than you would for a variable-rate loan. You may not always be able to pay off your loan whenever you want, and you may have to pay a fee if you switch to a variable rate or refinance.
Split rates
A split rate is a loan setup where a portion is on a fixed rate, and the rest is on a variable interest rate. It gives you an element of predictability (and a level of protection against rate fluctuations) while allowing you to benefit from rate drops and take advantage of the flexibility that comes with variable rates.
A split home loan can be like having the best of both worlds!
Honeymoon rates
A honeymoon rate is an introductory or discount rate that many lenders offer new customers. The low rate will only apply for a short period of time before going back to the typical amount.
While honeymoon rates can be attractive, it’s important not to get swept up in them and to make sure you can manage the loan once the honeymoon period is over.
How have interest rates changed over time?
The RBA’s historical data shows that interest rate changes in Australia have moved in cycles and experienced large swings over the years – from record highs at the start of the 1990s to the long-term dips of the 2000s and record lows of 2010s, all the way to the rapid, sharp upward trend in recent years.
- The early 90s saw extremely high rates of up to around 17%, which then dropped sharply almost halfway through the decade. This period was marked by the economy coming down from very high inflation.
- From the mid 90s to the mid 00s, Australia witnessed a relatively steady period of economic growth. Rates hovered between around 4% and 7% and moved up and down but only in smaller cycles.
- From 2008 to 2009, there was a noticeable drop from about 7% to around 3% due to the global financial crisis, when rates were cut to support the economy.
- There was a gradual decline to record lows from the mid to late 2010s, falling to around 1% or lower – reflecting a long period of low inflation and slower growth.
- Rates hit even lower – close to 0% – during the COVID-19 period when the economy needed strong support. From 2020–2022 during the COVID-19 pandemic, the RBA made the cash rate very low to encourage spending.
- In May 2022, the RBA began raising the cash rate to try and combat inflation, and banks and lenders passed the higher cash rates onto their customers in the form of higher interest rates on home loans. Between May 2022 and November 2023, the RBA raised the cash rate thirteen times, increasing interest rates to 4.35%.
- In 2025–26, the RBA reduced the cash rate three times then increased it three times, ending the financial year at 4.35%. These moves reflect the RBA’s effort to support economic growth while keeping inflation within its target range.
What affects my home loan interest rates?
Your interest rates are influenced by the RBA cash rate, loan types and the risk margin determined by your lender. The risk margin is based on your risk profile, which is informed by your purpose for getting a home loan, credit history and loan-to-value ratio (LVR).
RBA cash rates
With every change in the official cash rate set by the RBA, commercial banks and lenders generally adjust their variable interest rates to keep their profit margins.
Loan types
Fixed-rate loan rates will usually start off higher than variable home loan rates, though this can vary over the life of the fixed-rate period as variable rates change.
And when it comes to repayment types, principal and interest loans also generally come with lower interest rates than interest-only loans because the borrower is actively paying down the principal (and the balance), which is of lower risk to the lender.
Loan purpose
Many lenders offer different interest rates depending on whether the loan is for an investment property or a place to live, with owner-occupier loans generally having lower rates than investment loans.
Loans for investment properties tend to have higher interest rates because there’s more risk involved, especially if the investor relies on the rental income to make the repayments.
Credit history
For people with a poor credit score or with a history of not being able to pay back other loans like their credit cards, lenders might charge higher interest rates because of the perceived risk.
Loan-to-value ratio (LVR)
If you have a smaller deposit and therefore a higher LVR, lenders may charge higher interest rates. The bigger your deposit, the lower your LVR will be.
LVR is the loan amount expressed as a percentage of the value of the property – it’s the size of your loan compared to the property’s value.
How is interest calculated on a home loan?
Home loan interest is usually calculated daily by multiplying your current interest rate (per annum) by your outstanding loan amount, then dividing it by 365.
If you like formulas (and who doesn’t?), here’s what it looks like.
(principal x rate) ÷ 365 = daily interest
Here’s how our fictional friend, Sarah, calculates her interest.
- Sarah takes out a variable loan of $500,000
- Her interest rate is 5% per annum
- $500,000 x 5% = $25,000 (her yearly interest)
- $25,000 / 365 = $68.50 (her daily interest)
- Sarah’s interest is charged monthly, so for a 30-day month her interest is: $68.50 x 30 = $2,055
Remember that this is only to calculate the interest. If Sarah’s loan is principal and interest, she’ll be paying $2,055 monthly on top of whatever her principal repayment is.
How can I reduce my interest?
To reduce your interest, you can focus on paying down the principal balance, repay more frequently, restructure your debt or refinance (we can help you compare home loans to see if you can find a cheaper rate elsewhere).
If you already have the lowest interest rate you can find, there are also steps you can take to reduce the amount of interest you pay over the lifetime of your loan. Here’s what you can do.
Reduce your loan amount
Taking out a principal and interest loan, rather than an interest-only loan, will help you do this. Getting a home loan that allows you to make extra repayments, or that has redraw facilities or an offset account, can help you pay down your loan balance sooner, possibly saving you thousands of dollars in interest repayments.
Your interest is calculated on the principal of your loan. Reduce the principal, reduce your interest repayments.
Choose an offset account
If you choose an offset account, you get something like an everyday transaction bank account linked to your home loan account and get however much money is in there deducted from the principal when your monthly interest is calculated. Let’s say you have a $500,000 home loan. If you have $30,000 in savings that you keep in your linked offset account, your interest will be calculated on $470,000 instead of the full amount!
You can have your salary, for instance, paid directly into it and also instantly transfer money in and out as often as you like.
Shorten your loan term
Cutting the time period in which you’re paying your home loan means less time paying interest. A shorter loan term could help you save tens of thousands of dollars in interest payments through the entire life of your mortgage.
Heads up, though: doing so may lead to higher repayments. Of course, you have to be realistic about what you can manage. If you opt for a shorter loan to save on interest in the long term but end up in financial stress in the short term, is it really the way to go?
But if you feel like you can manage refinancing and manage higher repayments, then you might consider calling your lender to shorten your loan term.
Repay more frequently
Did you know that if you switch to more frequent repayments, you’ll end up paying less, even if you don’t pay any extra towards your loan?
It’s not magic, it’s maths. Here’s how it works.
Most lenders will automatically set up your loan so you make monthly repayments but will allow you to switch to fortnightly or weekly repayments if you ask. Here’s where the maths magic comes in: 26 fortnightly repayments of $1,000 ($26,000) equals more than 12 monthly repayments of $2,000 ($24,000).
Voila, you’ve paid off $2,000 more without (hopefully) noticing!
Helpful tip
You can often negotiate your home loan rate. If your lender’s offering better rates to new customers, ask why you’re not getting the same. Found a sharper rate elsewhere? Even better. Most banks would rather match it than lose your business. If you’re not confident, you can ask your broker to make the call for you.
Sam Hyman
General Manager – National Sales, Aussie
Where can I compare home loans?
You can compare home loans through comparison sites like iSelect, who’ve partnered with the experts at Aussie!
It could pay off to put in the time and effort to compare interest rates. The good news is that you don’t have to tackle it alone. We can make the process of comparing home loans easier for customers using our online tool. Make sure you compare the overall cost of the loan, including interest and fees. Lenders are required to list a comparison rate that shows both.
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