Interest Rates: What they are and how they work

What is an interest rate?

When you borrow money for a home, you need to pay back the principal (the amount you borrowed), plus interest. The interest is a charge that the lender places on top of the principal as payment for use of their money. The interest rate is expressed as a percentage of the principal, and determines how much interest you’ll have to pay each month. As you’ll see later, there are different types of interest structures available.

What factors determine how much interest I pay?

Depending on economic conditions, such as the Reserve Bank of Australia's (RBA) cash rate, and other potential changes to how much it costs lenders to fund loans, interest rates are constantly reviewed. Some other factors that could affect the interest you pay can include:

• How much you borrow: Unsurprisingly, the more money you borrow means the more you’ll typically have to repay. And that will mean you’ll be charged more interest over the life of your loan.
• What the loan is for: With home loans, you’ll usually be borrowing for either a house you’re planning to live in, or an investment property. Typically, investment loans can attract higher interest rates.
• Whether your loan is fixed or variable: If you take out a fixed rate loan, your interest will be locked-in for a set period, offering a degree of certainty. With a variable loan, your interest rate will change in line with economic conditions (this means it could go up or down).
• Whether you pay principal and Interest or interest-only: With a principal and interest loan, the bulk of your monthly payments will be the interest charge and a smaller amount is taken off your principal. The other option is an interest-only loan. As the name suggests, with the latter you only make interest repayments and don’t reduce the principal. Typically, you can only pay interest-only for a limited period.
• The lender’s financial needs: lenders don’t just alter interest rates when the RBA changes the cash rate. To cover their financial needs or an increase in the cost of lending, the lender may increase interest rates. On the other hand, lenders sometimes lower rates in order to remain competitive and attract more customers.

What are the different types of interest rates?

When it comes to loans, there are a few interest rate options, each offering their own particular features.

• Variable interest rate: The most common choice, a variable loan sees your interest rate fluctuate along with the market. If the cost of lending goes up, then the banks tend to pass this cost on to consumers in the form of higher interest rates. Home loans with variable interest rates typically come with more flexibility and available home loan features (e.g. 100% offset accounts).
• Fixed-interest rate: With a fixed-interest rate loan, you fix the interest rate that you pay for a set period of time so that it stays the same regardless of market conditions. The time you lock it in for will generally vary between one to five years.
• Split rate: A split rate loan is like having an each-way bet where you fix part of your loan while the other portion remains variable. This offers a combination of the certainty of a fixed loan, and the opportunity to make the most of potentially low variable interest rates.
• Honeymoon rate: To attract new customers, lenders will offer very low introductory interest rates on home loans. This special rate will only apply for a short period and will then revert to a more typical amount. It’s important to not get swept up in honeymoon rates and other introductory offers that lenders use to lure in customers. Always think of the big picture but remember that you will likely have the opportunity to refinance later.

How is interest calculated on a home loan?

Here’s where a little maths comes into play. To calculate your interest payments your lender takes the amount of your loan and multiplies it by your interest rate. Next, they divide that amount by 365 days (or 366 days if it happens to be a leap year). So, in formulaic terms, this process is expressed as (principal x rate) ÷ time = interest. So as an example, if you took out a loan of $400,000 at an interest rate of 3.5% p.a., the formula would be ($400,000 x 0.035) ÷ 365 = $38.36 per day.

Can I reduce the amount of interest I pay?

The good news is, yes, there are things you can do to help reduce the amount of interest you get charged over the life of your home loan.

The first, and most obvious, step you can take is compare a number of lenders and loan types to find a suitable option for you. And that’s where we can help—we’ve partnered with Lendi to make the process of comparing home loans easier for iSelect customers. Click here to get started!

But once you’ve found your loan, there are other approaches that can help you save. These include:

Reducing your loan amount:

As we pointed out earlier, your interest is calculated on the principal of your loan. So it stands to reason that if you reduce the principal, you generally reduce your interest repayments. That’s why taking out a principal and interest loan may be a better choice than opting for an interest only loan. A home loan with the option to make extra repayments could help you pay down your loan balance sooner, possibly saving you thousands in interest.

Shortening your loan length:

Quicker isn’t always better, but when it comes to home loans you may want to take the shortest loan term that you can manage. While a longer loan might mean smaller monthly repayments, it can add thousands to the total interest you end up paying. Always be realistic about what you can manage as you want to avoid missing repayments, defaulting and damaging your credit score.

Repaying more frequently:

OK, this one almost seems like a magic trick. Most lenders will let you choose to make repayments weekly, fortnightly, or monthly. And here’s the sneaky bit; if you pay fortnightly rather than monthly, you actually end up paying an extra month each year. That’s because there are 26 fortnights annually, not 24. And because this additional payment is effectively spread out over a year, you can reduce your principal without even noticing.

Choosing an offset account:

Many lenders offer offset accounts, but what does that mean? Well, an offset account works like a normal day-to-day savings account, so it’s where you might have your salary deposited and keep any savings. But unlike an ordinary account, it’s linked to your home loan and rather than earning interest, the money in your offset is deducted from your principal when your monthly interest charge is calculated. So it’s another great way to trim your repayments and get you closer to financial freedom.

For example, if you had a $400,000 home loan with $30,000 in a linked offset account, you will only be charged interest on the first $370,000 of your loan balance.

How can I compare interest rates?

When comparing interest rates, it could pay to do your due diligence. Be sure to consider the overall cost of the loan (lenders are required to list a ‘comparison rate’, which includes both the interest and the fees). But as we’ve demonstrated in this article, there is a lot to consider. The good news is that you don’t have to tackle it alone.

At iSelect we’ve partnered with Lendi to make the process of comparing home loans easier for iSelect customers. Use our online tool to compare home loans, or give Lendi a call on 1300 186 260 (08:30-18:30).

Sources:
1. https://moneysmart.gov.au/home-loans/choosing-a-home-loan
2. https://www.qld.gov.au/housing/buying-owning-home/advice-buying-home/deciding-to-buy/understanding-interest-rates

Last updated: 23/06/2021