What is compound interest and how does it affect your home loan?

As a borrower, you’re probably all too familiar with the concept of interest and how these repayments are tacked onto your total loan repayments. But do you understand the basics of how compound interest actually works, and the effect it can have on your mortgage?

Read on to learn more about this type of interest and a few tips on how to beat compound interest when you take out a home loan.

What is compound interest?

First things first, what is compound interest? Compound interest is a special type of interest that’s often applied to loans or savings accounts. It’s calculated based on both the initial principal and the accumulated interest from previous periods.

Alternatively, simple interest is calculated only on the principal amount. Compound interest takes into account the interest that has been added to the principal over time, allowing it to "compound."

While compound interest can help you to grow your savings quicker than simple interest, it also means that your debt can quickly add up when it’s used to calculate interest on a loan.

How to calculate compound interest

Chances are you would have touched on how to calculate compound interest in school, but here’s a quick refresher in case you haven’t had to think about that formula since.

The key components of compound interest include:

• Principal (P): The initial amount of money invested or loaned,
• Interest Rate (r): The annual interest rate, expressed as a decimal,
• Number of Compounding Periods per Year (n): How often the interest is applied (EG. annually, semi-annually, quarterly, monthly or daily), and
• Time (t): The length of time the money is invested or borrowed, in years.

To calculate the future value of an investment or loan, you’d use the following formula:

A = P (1+rn)^nt

Where:

• 𝐴 is the amount of money accumulated after n years, including interest,
• 𝑃 is the principal amount (the initial sum of money),
• 𝑟 is the annual interest rate (decimal),
• 𝑛 is the number of times that interest is compounded per year, and
• 𝑡 is the time the money is invested or borrowed for, in years.

Calculating interest on a home loan

Most home loans calculate interest daily, which is then charged on a monthly basis. So, at the end of each day, your lender will take your outstanding loan balance, multiply it by your home loan’s interest rate and divide it by 365 (or 366 during a leap year) to calculate your daily interest charge.

The more frequently interest is compounded, the greater the amount of interest accrued. Because of the rate at which the compound interest is calculated on home loans, it tends to have a snowball effect on your outstanding loan balance. With this in mind, it makes sense to try and pay off as much of your loan as possible, particularly in those first few years when you’re mainly paying off your interest. Plus, making additional payments towards the principal can also reduce the total interest paid and shorten the loan term.

Let’s say you took out a home loan for $500,000 (P) at an interest rate of 5.90% pa (r). To work out your daily interest charges (I), you would use the following formula:

(P x r) / T = I

(500,000 x .059) / 365 = $80.82 interest charged daily

Calculating compounding interest on a home loan starts getting complicated as you make mortgage repayments and your interest charges are added. Luckily, there are mortgage calculators that you can use to help work out your potential repayments and savings.

Ultimately, as you chip away at your outstanding loan balance, your interest charges will slowly decrease, allowing you to pay off more of your mortgage.

How to beat compound interest

When it comes to home loans, there’s no way to hack the system. The only real way to minimise the amount of compound interest you pay over the life of your loan is to try and pay off your loan as quickly as possible. 

Here are a few tips to help you minimise your potential interest repayments over the life of your home loan.

Put down a bigger deposit

Although it’s easier said than done, try to put down a large deposit. The more you pay upfront, the smaller your outstanding balance will be and the less compound interest you’ll be charged. Plus, if you’re able to pay at least 20% or more of the purchase price upfront, you’ll also be able to avoid paying lender’s mortgage insurance (LMI) or a low deposit premium (LDP).

Make fortnightly repayments

It might not seem like much, but switching your repayments from monthly to fortnightly can help you to pay down your home loan quicker. Here’s how it works. If you’re currently paying $4,000 a month toward your home loan, you can change the frequency of your repayments to $2,000 a fortnight instead. While this might sound like the same thing in theory, over a year you’ll actually end up making more repayments, which could save you on interest in the long run. 

If you pay $4,000 every month for a year, your total annual repayments work out to be $48,000. However, by paying $2,000 a fortnight over the course of a year (or 26 fortnights), you’ll end up paying $52,000 a year.

Make additional repayments

Another option to help you pay off your mortgage quicker is to make additional repayments. But before you go sinking extra cash into your home loan, it’s worth making sure that you’re able to make additional repayments without being penalised. 

It’s also important to take a look at your budget to make sure you have a little extra cash to spare. With that said, if your loan has a redraw facility, you may be able to make additional repayments above your minimum repayment and redraw the extra money later down the line if you need a top-up for any reason. 

You can read more about how redraw facilities work here. 

Compound interest is just part and parcel of taking out a home loan. With that said, it helps to understand how compound interest works so you can take steps to pay off your mortgage sooner and minimise your interest repayments.

If you’re looking to take advantage of a competitive interest rate, check out what’s on offer at Unloan. Whether you’re looking to buy a home or refinance your current home loan, we’ve got you covered. Take a look at our home loan features today.

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This article is intended to provide general information only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. Please consider seeking financial advice before making any decision based on this information.‍

Unloan is a division of Commonwealth Bank of Australia.

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