How interest gets calculated on your home loan

As a basic rule, mortgage interest is calculated each day, based on the amount of money (or principal) still owing on your loan. As the principal declines, so does the borrower’s interest bill.

For example, if someone took out a $500,000 principal-and-interest loan, interest would be charged initially on $500,000; but if, say, a year later, they’d repaid $15,000 of their loan, interest would be charged on $485,000.

It’s important to note that, with a principal-and-interest loan, the principal does not decline in a linear way. That’s because, in the early days of the mortgage, most of each monthly payment is allocated towards paying interest rather than reducing the principal. 

If the borrower’s $500,000 loan had a 30-year term, your principal would decline something like this:

• After 5 years = about 94% of the principal would remain.
• After 10 years = 85%. 
• After 15 years = 73%.
• After 20 years = 56%.
• After 25 years = 32%.
• After 30 years = 0%.

Interest-only loans

The situation is different with an interest-only loan.

Let’s say the above loan was interest-only for the first five years of the 30-year term, before reverting to principal-and-interest for the final 25 years. In that case, during the first five years, the borrower would be paying nothing but interest – which means their monthly repayments would be lower during that period, but their principal would still be as large at the end of that period. As a result, their principal would decline something like this:

• After 5 years = 100% of the principal would remain.
• After 10 years = 91%.
• After 15 years = 78%.
• After 20 years = 59%.
• After 25 years = 35%.
• After 30 years = 0%.

Additional repayments and offset accounts

Given that mortgage interest is charged each day on the borrower’s outstanding loan amount, the faster they can reduce the principal, the less interest they’ll pay over the life of the loan.

This can be done in two ways.

The first is to literally reduce the principal, by making extra repayments (assuming the loan allows for that).

The second is to ‘virtually’ reduce the principal, by transferring extra money into an offset account (assuming the loan has one). The borrower will then be charged interest not on the remaining principal, but on the principal minus your offset balance. So if they had $470,000 remaining on their loan and $10,000 in their offset account, they’d be charged interest on only $460,000.

Please note, though, that if they then withdrew this $10,000 – perhaps to pay for a holiday – they would be left with $0 in their offset account and would be charged interest on the full $470,000.