Don’t worry, this won’t turn into a heavy math lesson, but all borrowers must understand the basics of compounding interest to ensure they benefit from it (or at least minimise the damage).
On almost every home loan I have ever seen, including all the major banks and smaller lenders, interest is “calculated daily” and “charged monthly in arrears”.
Key Point:
“Calculated daily” means that if you owe $300,000 at 7%, your daily interest cost is $57.53. So over a 30 day month, it will add up to $1726.03.
“Charged monthly in arrears” means this interest cost is added to your loan once at the end of the payment month.
If your loan settled on the 16th of January, the bank will then add this interest to your loan on the 16th of February and the 16th of every subsequent month. So on the 16th of February you owe $301,726.03. Then, when your $2,000 monthly repayment hit your account, you owed $299,726.
How does knowing this help you?
First – the bad news
If you miss your repayment for any reason, the interest starts compounding—you start paying interest on top of your interest. If on the 16th of February you didn’t pay $2,000, you would now be getting charged interest on a debt of $301,726.03.
Actually, it’s worse than that. Most lenders will charge a “penalty” interest rate if you are behind in your repayments, usually around an extra 2%. So using the above example, if you missed a repayment you are now accruing interest at $74.40 every day (instead of $57.53). If you miss again it will get worse every month and can quickly spiral out of control.
For that reason, it is very important to get a surplus in your payments as soon as possible. It is also worth considering income protection or credit protection insurance to safeguard against unforeseen circumstances.
This is why you should take the maximum available loan term with a lender that allows you to pay extra. That way you can set your repayments as high as you want, but you can reduce them as well if you lose your job or become ill and could not work.
Now – the good news
Knowing that interest is calculated daily, it makes sense to have money in the loan (or in a 100% Offset Account) as quickly as possible. If you are paid weekly, you should make weekly repayments on your loan.
Also, you should “park” any money that is not currently being used into the home loan (if you have a loan that has a redraw facility). This money will be available as a redraw if you want it later. Every day it is in your loan it reduces the interest you are paying, so your repayments reduce more of the principal of the loan, and in turn you pay less interest next month. This way, you can compound your interest savings.
You should think of your home loan like any bank account, it just has a negative balance so you get charged interest at a high rate instead of earning it a low rate.
It is better to leave your money in your home loan instead of a savings account because you pay tax on the interest you earn, but not on the interest you save.
Make sure you have a home loan that offers a free redraw facility and allows you to make extra repayments at any time at no cost. Some lenders charge a fee to redraw your money, which can discourage you from paying extra.