What is interest?
Whenever you hear people talking about home loans, the subject of interest rates is never far behind. And with good reason — the interest rate is essentially the price at which a bank charges you for the loan. It varies over time as it rides the fluctuations of the wider, global economy, and plays a huge part in how much your home loan will cost over the years.
How interest works
When you borrow money, your minimum repayments are actually made up of two parts — first the interest cost on your loan is paid, then whatever is left over goes towards reducing the principal (that’s the amount you actually borrowed). As time goes by, the principal gradually goes down. Since the interest portion is calculated based on how much principal you still owe, it means the interest costs gets smaller over time. The great thing about this is, whenever you pay more than the minimum repayment, every extra cent paid comes straight off the principal portion of the loan. This means that your interest payments from this point on now get calculated using the new, smaller principal amount. It may not seem like much, but down the track the potential savings on interest can be huge.
Work the system
What banks do is create different home loan products that offer various ways of taking advantage of the way interest works all with varying degrees of freedom. Let’s take a look at some of those options.
Fixed rate loans
A fixed rate lets you lock in an interest rate for a period of time (usually measured in years). This gives you a degree of certainty in that you know exactly how much your home loan repayments will be for the next few years and lets you budget with confidence because you’re essentially immune to interest rate fluctuations during this fixed rate period.
Eyes wide open
Of course, the ‘lock in’ goes both ways. If you decide you want to change to a different rate or otherwise exit the fixed term early, there may be a cost associated with doing so. How much this is depends on a variety of factors, including: the amount of the loan being repaid, how much lower current wholesale rates are compared to the wholesale rates at the start of the fixed rate period, and the time left on the fixed rate period.
Some fixed rate loans let you make extra payments to reduce the principal and interest, but only up to 5% of the loan balance at the start of your current fixed rate period, per year (this may differ from bank to bank).
Floating rate loans
Floating rates, on the other hand, go with the flow and as such can go up or down at any time. This is great if rates go down as you can benefit from the reduced cost immediately. You can also change your loan structure and make extra payments as often and as large as you want. However, if rates go up, you’re vulnerable to this extra, unbudgeted cost.
Mix ‘n match
You don’t have to choose one or the other, some people prefer to mix things up by placing part of a loan on a fixed rate while leaving the rest on floating. This lets you take advantage of interest rate drops and extra repayments, while still retaining a degree of certainty thanks to the fixed portion.
Even something as simple as switching from monthly to fortnightly repayments can help reduce interest costs over the course of a year. How come? Paying monthly means 12 payments in a year, whereas fortnightly means 26 payments per year — you’re making two extra payments each year without really trying.
The bottom line
When it comes to interest, the less time you spend paying off a loan, the less interest you’ll pay. If you remember this one guiding principle when you’re making decisions related to your home loan, you’ll pay less in the long run and be mortgage free sooner. Above all, talk to your bank about which option is best suited to your individual situation.