How extra repayments reduce home loan interest
Interest on an Australian home loan is generally calculated daily on the outstanding balance and charged monthly. The minimum repayment is set so that the debt is cleared over the contracted term, and in the early years most of each repayment is absorbed by interest. On a hypothetical $500,000 loan at an illustrative 6.00% per annum over 30 years, the first monthly repayment of approximately $2,998 comprises $2,500 of interest and less than $500 of principal. Progress in reducing the debt is therefore slow at the outset.
An additional repayment alters that position because the whole of it is applied to principal. The balance falls by the full amount, interest is calculated on a lower figure on every subsequent day, and a larger share of each later minimum repayment is in turn applied to principal. The benefit compounds for as long as the loan remains on foot. For that reason a modest regular amount may remove years from a loan, and the same sum paid early in the term saves considerably more than it would if paid late.
How the extra repayments calculator models the loan
The calculator first determines the minimum principal and interest repayment for the balance, rate and remaining term entered. It then simulates the loan twice, month by month. In the first simulation only the minimum is paid. In the second, the additional monthly amount is added to every repayment from the first month until the balance reaches nil. In each month, interest at one twelfth of the annual rate is added to the balance and the repayment is deducted.
Three results are drawn from the comparison. Interest saved is the difference between the total interest charged in the two simulations. The reduction in loan term is the difference in the number of months taken to repay the debt, and the new payoff time is the length of the second simulation. The model assumes a constant interest rate, monthly repayments, no fees and a loan that accepts unlimited additional repayments. Actual loans accrue interest daily and rates change over time, so the figures are estimates intended for comparison and planning, and not a statement of what a particular lender will charge.
Choosing the inputs: balance, rate, term and extra amount
The loan balance should be the amount currently owing, and the remaining term should be the number of years left on the contract, both of which appear on a loan statement. The interest rate should be the rate actually charged. Because the rate will vary over the life of a variable loan, it is useful to run the calculation at the current rate and again at a rate one or two percentage points higher. A higher rate increases the interest saved by each additional dollar, although it also increases the minimum repayment.
The additional amount should be a figure that can be sustained through ordinary months and not only favourable ones. A household budget that allows for irregular expenses such as insurance, registration and school costs gives a more reliable indication than the surplus left at the end of a single pay cycle. Borrowers paying weekly or fortnightly may convert their intended extra payment to a monthly equivalent by multiplying a weekly amount by 52, or a fortnightly amount by 26, and dividing by 12. The BorrowWise mortgage repayment calculator shows the minimum repayment at each frequency.
Illustrative example: an extra $250, $500 or $1,000 a month
Consider again the hypothetical $500,000 loan at an illustrative constant rate of 6.00% per annum with 30 years remaining. The minimum repayment is approximately $2,998 per month, and interest over the full term is approximately $579,000. An additional $250 per month from the outset would reduce total interest by approximately $123,000 and repay the loan in 24 years and 7 months, which is 5 years and 5 months ahead of the contracted schedule.
Doubling the additional amount to $500 per month would save approximately $199,500 in interest and repay the loan in 21 years, nine years ahead of schedule. An additional $1,000 per month would save approximately $292,000 and repay the loan in 16 years and 5 months. The pattern is worth noting. Each increase produces a further saving, but the first dollars have the greatest effect, because they remove the most distant and therefore the most expensive years of the loan. Small amounts are consequently not futile, and borrowers need not wait until a large surplus is available.
Why starting early matters when paying off a home loan faster
Timing affects the result as much as the amount. In the hypothetical example above, an additional $500 per month from the first month saves approximately $199,500. If the same borrower paid only the minimum for the first ten years, the balance would still be approximately $418,000 with 20 years remaining. Commencing the additional $500 per month at that point would save approximately $80,000 in interest and shorten the loan by 4 years and 9 months. The saving remains substantial, but it is less than half the amount available from an early start.
The explanation lies in the structure of a principal and interest loan. In the early years the balance is at its highest and interest makes up most of each repayment, so a dollar of principal repaid early avoids interest for the longest possible period. The effect of different remaining terms may be tested directly by adjusting the term slider. Borrowers who are well into a loan may still benefit, and the BorrowWise mortgage payoff calculator approaches the same question from the other direction by showing the repayment required to clear the debt by a chosen date.
Fortnightly repayments and lump sums
A commonly used method of making extra repayments is to pay half the monthly repayment every fortnight. Because there are 26 fortnights in a year, the borrower pays the equivalent of 13 monthly repayments instead of 12. On the hypothetical loan above, the additional repayment each year is approximately $2,998, or about $250 per month, which corresponds to the first example: approximately $123,000 in interest saved and more than five years removed from the term. The benefit arises only where the fortnightly amount is half the monthly figure. Where a lender calculates a true fortnightly minimum, the annual total is unchanged and little is saved.
Lump sums such as a tax refund, a bonus or the proceeds of an asset sale operate in the same way as regular additional repayments, in that the whole amount reduces principal from the day it is credited. The calculator models a fixed monthly amount and does not accept a single lump sum. An approximate indication may nevertheless be obtained by reducing the loan balance by the lump sum while keeping the repayment in mind, or by dividing an expected annual bonus by 12 and entering the result as a monthly amount.
Extra repayments on variable and fixed rate loans
Most variable rate home loans in Australia accept unlimited additional repayments without charge, and many allow the funds to be withdrawn again through a redraw facility. Fixed rate loans are more restrictive. A Reserve Bank of Australia review published in March 2023 found that most fixed rate products limited prepayments, and that among the ten largest lenders the median allowance was $10,000 for each year of the fixed term. Amounts paid above the cap may give rise to break costs, so the contract should be checked before additional payments are made to a fixed loan.
A split loan is one means of retaining flexibility. One portion is fixed to provide certainty of repayments, while the variable portion accepts unlimited extra repayments and may be linked to an offset account. It is also worth confirming how the lender treats repayments when rates fall. The Reserve Bank has observed that many borrowers build substantial buffers simply by leaving their repayment unchanged when the minimum is reduced, which is an effortless form of additional repayment. The BorrowWise guide to fixed and variable rates sets out the wider considerations.
Extra repayments compared with redraw and an offset account
An extra repayment and an equal deposit into an offset account reduce interest by the same amount, since in each case interest is charged on a lower net balance. The difference lies in access and in the legal character of the money. Funds in an offset account remain the deposit of the account holder and are available at call. Funds paid into the loan have reduced the debt, and access through redraw depends on the terms of the lender, which may include minimum amounts, fees or a discretion to reduce the available redraw over time.
The distinction may have tax consequences where a property is, or may later become, an investment. Redrawn funds are generally treated as a new borrowing, and where they are applied to a private purpose the interest attributable to that portion is generally not deductible, whereas withdrawing savings from an offset account leaves the loan unchanged. Borrowers who may one day rent out their home may wish to obtain advice from a registered tax agent before making large repayments directly into the loan. The BorrowWise offset account calculator provides a comparison of the interest saved.
Common mistakes and acting on the result
The most common error is to commit every spare dollar to the mortgage and retain no accessible reserve. Reserve Bank research on household buffers indicates that borrowers who are ahead on their loan are better placed to withstand a loss of income, but only where the prepaid funds can be reached through redraw or offset. Other errors include making additional mortgage repayments while carrying credit card or personal loan debt at a much higher rate, exceeding the prepayment cap on a fixed loan, and assuming that additional repayments reduce the minimum repayment, which with most lenders they do not.
A practical course is to settle on a sustainable amount, confirm with the lender that additional repayments are credited to principal immediately and are available for redraw, and arrange an automatic transfer on each pay day. The amount may be reviewed whenever income or the interest rate changes. Borrowers whose rate appears high relative to current offers may also use the BorrowWise refinance calculator, since a lower rate combined with an unchanged repayment produces the same effect as an extra repayment. The results are general information only and do not take personal circumstances into account.
Extra Repayment Calculator: frequently asked questions
How much interest can be saved by making extra repayments?
The saving depends on the balance, the interest rate, the time remaining and the amount paid. As a hypothetical illustration, an additional $500 per month on a $500,000 loan at a constant 6.00% per annum over 30 years would save approximately $199,500 in interest and repay the loan nine years early. The calculator estimates the equivalent figures for any loan and monthly amount entered.
How can a home loan be paid off faster in Australia?
The principal methods are making regular additional repayments, paying half the monthly repayment every fortnight, applying lump sums such as tax refunds to the loan, holding savings in an offset account, and maintaining the same repayment when interest rates fall. Obtaining a lower rate through negotiation or refinancing, while continuing to pay the previous amount, has a similar effect. Each method reduces principal sooner and therefore reduces interest.
Can extra repayments be made on a fixed rate home loan?
Generally yes, but within limits. Many lenders cap additional repayments during a fixed rate period, commonly at a set dollar amount for each year of the fixed term, and break costs may apply where the cap is exceeded. The limit differs between lenders and products, so the loan contract should be reviewed, or the lender consulted, before additional payments are made.
Is it better to make extra repayments or use an offset account?
For an equal amount the interest saving is the same. An offset account keeps the funds available at call and avoids potential tax complications where the property later becomes an investment. Direct repayments may suit borrowers who prefer the funds to be less accessible, or whose loan has no offset facility. Loans with an offset account may carry a higher rate or an annual fee.
Do extra repayments reduce the minimum monthly repayment?
Usually they do not. With most Australian lenders, additional repayments shorten the life of the loan and place the borrower ahead of schedule, while the contracted minimum repayment remains unchanged until the interest rate moves or the loan is varied. Some lenders will recalculate the minimum on request. The practice of the particular lender should be confirmed.
Do fortnightly repayments pay off a mortgage faster?
They do where the fortnightly amount is half the monthly repayment. Twenty-six fortnightly payments equal 13 monthly repayments a year, so one additional repayment is made annually and is applied to principal. Where the lender instead calculates a lower fortnightly minimum that totals the same amount over the year, the loan term is largely unchanged and the benefit is negligible.
Should a lump sum be paid into the mortgage?
A lump sum reduces principal immediately and lowers the interest charged from that day forward. Borrowers may first consider whether an adequate cash reserve will remain, whether the funds could be redrawn without restriction if required, whether a fixed rate prepayment cap applies, and whether debts carrying a higher interest rate, such as credit cards, ought to be repaid first.
Are extra repayments better than investing or contributing to superannuation?
An additional repayment produces a certain saving equal to the loan interest rate, and that saving is not taxed. Investments and superannuation contributions may produce a higher or lower return, involve risk and differing tax treatment, and in the case of superannuation cannot ordinarily be accessed until retirement. The appropriate balance depends on individual circumstances, and a licensed financial adviser can provide personal advice.
Sources for the extra repayments guide
- Reserve Bank of Australia: Fixed-rate housing loans, monetary policy transmission and financial stability risks (Bulletin, March 2023)
- Reserve Bank of Australia: Households' mortgage prepayment buffers (Financial Stability Review, September 2012, Box B)
- Reserve Bank of Australia: Offset account balances and housing credit (Statement on Monetary Policy, August 2015, Box E)
- Reserve Bank of Australia: Lenders' interest rates