How Does Home Loan Interest Work?
Understanding how home loan interest works is crucial to managing your money while paying off your mortgage. Even if your interest rate remains relatively low, over the 20-30 years it takes to pay off the loan it will make up a large portion of your overall home loan expenditure. Understanding interest requires a basic understanding of elementary mathematical principles. In this blog post we explain how home loan interest works to help you gain control of your finances while paying off your home loan.
It’s easy to misinterpret how home loan interest functions. For example, when calculating interest on a $1 million mortgage, it’s tempting to think that a 3% interest rate means you only have to pay $30,000 on top of the balance of the loan. While this is true if the loan is paid off in one year, in general, home loans take a lot longer to pay off and the 3% interest rate compounds year on year. Home loan repayments will reduce the total amount of payable interest, but interest payments are still payable each year.
Our Example Continued
One common repayment model involves making monthly repayments on the home loan with a 3% interest rate. If the person pays $4,000 per month, the sum of the repayments they will make in one year is $48,000. This means $30,000 goes towards paying off the interest while the remaining $18,000 will go towards paying off the principal amount. At the end of one year, the person will have paid their interest in full and the balance of their principal payments will be $982,000. In year two, they will pay 3% interest on the remaining $982,000 and so on. At this rate, it will take 30 years to pay off the loan in full.
Reducing Interest Payments On A Loan
There are several strategies one can use to reduce the interest repayments on their home loan.
By making repayments every fortnight instead of every month, you contribute an additional two payments per annum towards your home loan. This quickly reduces the total amount owing on the loan principal and as a result reduces the total amount of interest you will have to pay.
Increase The Value of Repayments
If you can afford to, increasing the value of your repayments will help you to pay off your loan quicker. In the example above, paying an extra $1,000 per month will reduce the time taken to pay off the loan by approximately 8 years.
Reduce The Term of the Loan
Reducing the term of the loan will significantly reduce your interest costs. Consult your lender to see if it’s possible to switch from a 30-year loan to a 25-year loan. In the example above, doing so would reduce your interest payments by clost to $75,000.
Make Lump Sum Repayments
Making lump sum repayments towards a loan is another way to significantly reduce the interest you will pay. Even just $15,000 paid towards a $1 million loan will reduce the interest by more than $20,000 over the duration of the loan.
Contact Pillar Financial
Call our friendly team on 1300 730 309 or reach out via our contact page to ask what we can do for you as you begin your journey towards home ownership.