What is interest?

In finance, we deal with interest all the time. 

Products like savings accounts and term deposits, car and personal loans and, indeed, home loans, come with interest rates attached to them.

But what is interest?

To boil it down to its simplest form, interest is the cost of using someone else’s money.

That ‘someone else’ could be a bank, a lender, or even you. 

In the same way that you can earn interest from a bank when you keep your money inside a high-interest savings account, home loan lenders earn interest when they lend money to you to buy a home. 

The interest is calculated using an interest rate.

Now we know what interest is – the price you pay to borrow and use another party’s money – we can look at how interest is charged. 

Interest is charged at a specified rate, usually set by the financial provider (i.e. the bank or lender). This is known as the interest rate. 

An interest rate is a bit like the price tag on a t-shirt at a clothing store. Except that the t-shirt, in this case, is the money you’re borrowing. 

When you compare home loans, it’s important to shop around for a competitive interest rate. We’ll get to why in a moment.

When you get a home loan, you’ll have to repay both the initial amount you borrowed (known as the principal) and the interest you build up while paying down your loan. 

In short, interest is calculated using the amount you still owe, according to your interest rate. 

Deciphering 'p.a.'

A typical home loan interest rate (in 2024, at least) might be around 6% p.a. – the ‘p.a.’ meaning ‘per annum’, or per year. 

How is home loan interest calculated?

Your lender will usually calculate interest on a daily basis, which you’ll then pay in monthly instalments, along with your principal repayments. 

To illustrate, say you’ve borrowed $600,000 from your lender to buy a home, at an interest rate of 6% p.a., and you’ve got 25 years to pay off the loan.

To calculate your daily interest, you’ll want to take your principal amount ($600,000) and divide it by your per annum interest rate (6% p.a., or 0.06 if you’re plugging the numbers into a calculator).

Then, simply divide that number by 365 days to get your daily interest amount. 

In this case, your daily interest works out to be about $98.63. 

However, as you repay your principal amount (the $600,000 in the example above), your interest repayments could decrease.

Interest rates can change a lot and often do. 

There are lots of factors that might make interest rates go up and down, like the Reserve Bank of Australia (RBA) changing the official cash rate, for instance. 

In the case of the RBA, lenders may be able to borrow money from them, on which they’ll be charged interest, according to whatever the cash rate is set at. So, when the cash rate goes up, lenders can cover those costs by passing them on to you. 

That’s what might cause your home loan interest rate to rise, especially if you’re on a variable rate. 

Variable rates are pretty standard, but there are also other types of interest rates out there.

There are three types of home loan interest rates you’ll commonly find. These are variable, fixed, and split-rate home loans. 

Variable rates 

Variable rates rise and fall over time. This means you can typically expect lower variable interest rates when the economy is running smoothly, and higher variable rates when inflation is high.

Fixed rates 

Fixed rates are useful when variable rates are rising because you can hold your interest rate where it is for a period of 1 to 5 years. Think of fixed interest rates as putting a lock on your rate.

Split loan 

Split interest rates are a mixture of the previous two, where a portion of your loan balance is charged with variable interest while the other portion is charged with fixed interest. These are less common and may cost you a bit more in fees.

What makes a good interest rate is subjective, but you ultimately want one that helps you to keep your mortgage repayments affordable, without accruing too much interest. 

At the time of writing, the average variable home loan interest rate for owner-occupiers in the Mozo database (P&I, $400k, <80% LVR) is 6.82% p.a. However, the lowest rate is down at 5.79% p.a. 

If you’re in the market to buy in 2024, then make sure you compare home loans to help you find a good interest rate, while also keeping an eye out for the home loan features you might also like.