How mortgage interest is charged and repaid

Interest is charged on what you still owe

A home loan has no interest built into it in advance. Each period the lender applies the periodic rate to whatever principal is outstanding at that moment, and your repayment pays that charge first. Whatever is left over reduces the principal, which makes the next period’s interest charge slightly smaller. That is the entire mechanism, and every surprising feature of a mortgage follows from it.

The repayment itself is the constant amount that happens to clear the balance to zero in exactly the agreed number of periods. For a principal P, a periodic rate i (the annual rate divided by the number of repayments a year) and n repayments, that amount is:

M = P × i ÷ (1 − (1 + i)^−n)

$600,000 at 6.00% p.a. over 30 years, paid monthly:
  i = 0.06 ÷ 12 = 0.005
  n = 30 × 12  = 360
  M = 600,000 × 0.005 ÷ (1 − 1.005^−360) = $3,597.30

Interest in any one repayment = balance at the start of the period × i
Principal in that repayment  = M − that interest charge

The first repayment on that loan carries $600,000 × 0.005 = $3,000.00 of interest, leaving $597.30 to come off the debt. Nothing about the repayment is unfair or front-loaded; it is simply that a very large balance generates a very large interest charge, and $3,597.30 does not go far against it. The compounding that drives this is the same mechanism that works in your favour on savings — see compound interest, and why frequency matters for that side of it.

The split at year 1, 5, 15 and 25

Because the balance falls, the interest portion of a level repayment falls with it, and the principal portion rises by exactly the same amount. The repayment never changes; only its composition does. These are the individual repayments made at four points in the same $600,000 loan at 6.00% over 30 years.

Read the last column rather than the first. Five years and $215,838 of repayments into this loan, the balance has fallen by only $41,674 — the other $174,164 was interest. The halfway point in time is nowhere near the halfway point in the debt: at fifteen years, $426,293 of the original $600,000 is still outstanding. Over the full term the borrower repays about $1,295,028, of which about $695,028 is interest.

Why $100 extra in year one is worth far more than $100 in year twenty-one

An extra repayment does not buy you a discount. What it buys is the permanent removal of every future interest charge that dollar of principal would have generated. A dollar taken off the balance in month one avoids 359 months of compounding; the same dollar in month 300 avoids sixty. The dollar is identical, so the difference is entirely the time it has to work.

Now hold the extra money constant and move only its timing. Sixty payments of $100 is $6,000 either way, but when it is paid changes what it achieves.

The early $6,000 does more than seven times the work of the late $6,000. This is also why a lump sum matters so much at the start: $10,000 paid off in month one saves about $47,981 in interest, while the same $10,000 paid in month 240 saves about $8,101. If you are still saving for a purchase rather than paying one off, the same logic applies to the deposit — a larger deposit means a smaller balance generating interest from day one, and a lower loan-to-value ratio, which is what determines whether lender’s mortgage insurance is charged at all.

Offset, redraw and extra repayments do the same job differently

These three are constantly compared as though one were mathematically superior. They are not, or at least not by much: all three reduce the principal that the interest rate is applied to, and a dollar removed from the interest calculation is worth the same however it got there. What separates them is what happens when you want the money back, and what the arrangement costs to hold.

The differences that actually decide it

• Access. Offset money is yours to spend at any time. Redraw is a request to the lender, and lenders can change redraw limits or availability.
• Cost. Offset accounts are frequently bundled into packaged loans with an annual fee, and a partial offset credits only some of the balance. A fee that exceeds the interest saved makes the feature a net cost, which is worth checking against your actual average balance rather than your best month.
• Tax treatment on investment loans. Money sitting in an offset account has not been paid off the loan, whereas redrawing repaid principal is generally treated as new borrowing whose deductibility depends on what the money is used for. This is a genuine difference with real consequences and it is a question for a registered tax agent, not a calculator.
• Behaviour. An offset balance you keep dipping into saves less interest than the headline suggests, because the interest saving only applies while the money is actually there.

Moneysmart’s guidance on mortgage offset accounts and paying off your mortgage faster covers the product features in more detail. Note too that a fixed-rate loan often caps extra repayments or charges a break cost, so the option to pay extra is not always available.

Interest-only periods, and the step up at the end

An interest-only repayment is calculated to cover the interest charge and nothing else. On the same $600,000 loan at 6.00%, that is $600,000 × 0.005 = $3,000.00 a month. It is $597.30 cheaper than the principal and interest repayment, which is the appeal, but the balance at the end of the period is exactly $600,000 — the same as at the start.

Two consequences follow. First, five years of interest-only repayments costs $180,000 and reduces the debt by nothing. Second, the loan still has to be repaid inside the original 30-year term, so the principal and interest repayments that follow have only 25 years to clear $600,000. That repayment is $3,865.81 a month, $268.51 more than if the loan had been principal and interest from the start, and the total interest over the full 30 years rises from about $695,028 to about $739,743.

Interest-only has legitimate uses — matching an investment structure, or bridging a period of reduced income — but the arithmetic is unambiguous: it defers repayment rather than reducing it, and it costs roughly $45,000 more on this loan to do so.

Two numbers that are not what they appear: the comparison rate and the fortnightly repayment

The comparison rate

The advertised interest rate prices only the interest. The comparison rate exists because a low rate attached to high fees can cost more than a higher rate with none, so lenders must also publish a single figure that folds the rate together with most standard fees and charges. It is a genuinely useful screening tool.

Its limitation is that it is calculated on a standard example loan set by regulation, not on your loan. If your loan is much larger or your term much shorter than the example, fixed dollar fees spread differently and the comparison rate will overstate or understate their effect for you. It also cannot capture fees that depend on behaviour, such as break costs or redraw charges. Use it to shortlist, then compare the actual dollar cost of the shortlisted loans over the term you intend to hold them — which is what the borrowing comparison calculator does.

Fortnightly repayments

The advice to switch from monthly to fortnightly repayments works, but not for the reason it is usually given. There are 12 months in a year and 26 fortnights, and 26 is not 24. If you pay half your monthly repayment every fortnight — $1,798.65 here — you pay $46,764.90 a year instead of $43,167.60. The difference of $3,597.30 is precisely one extra monthly repayment, and because it lands entirely on principal it clears the loan roughly five and a half years early and avoids on the order of $149,000 of interest.

The frequency itself contributes almost nothing. A loan genuinely priced fortnightly over 30 years has a repayment of about $1,659.50, which is $43,147 a year — effectively identical to the monthly schedule. So the question to ask a lender is not “can I pay fortnightly” but “will my fortnightly repayment be half the monthly one, or one twenty-sixth of the annual one”. Only the first is the thirteenth repayment in disguise.

What the OzCalc mortgage calculators do and do not model

The mortgage calculator applies the formula above with a nominal annual rate divided by the number of repayments a year. Real lenders generally accrue interest daily on the closing balance and debit it monthly, which is not identical. The difference is small on a single repayment and grows over a full term, so treat total interest figures as close estimates rather than statements of your account. The extra repayment and offset calculators simulate the loan period by period on the same basis.

• The rate is held constant for the whole term. No variable loan behaves this way, and a rate change resets the repayment.
• There are no fees: no application or settlement costs, no monthly or annual account fees, no lender’s mortgage insurance. A loan with LMI is a larger loan than the price minus the deposit.
• The offset calculator assumes a full 100% offset held at a constant balance, and does not reduce the scheduled repayment when the offset is present. A real offset balance moves with every pay and every bill.
• Extra repayments are assumed to continue every single period, and no redraw is taken back out.
• Nothing here tests whether a lender would approve the loan. Serviceability assessments apply an interest rate buffer above the actual rate and their own expense benchmarks.

Those simplifications are exactly why the comparison between two scenarios is more trustworthy than either absolute figure. The gap between paying $100 extra and not paying it is robust; the precise total interest to the nearest dollar is not. For the official estimator and the surrounding guidance, see Moneysmart’s mortgage calculator and its notes on choosing a home loan.

Common questions