One payment, two very different halves
A standard home loan repayment is a fixed amount, but what it does changes every month. Each payment first covers the interest accrued on the outstanding balance, and only what is left reduces the principal. Because the balance starts high, the interest share starts high too.
On a $500,000 loan at 6% over thirty years, the repayment is about $2,998. In the first month roughly $2,500 of that is interest and only $498 touches the principal. Fifteen years in, the split is closer to even. In the final year almost the whole payment reduces the balance.
This is why a mortgage feels like it barely moves for the first few years, and why paying it down early is disproportionately powerful: every dollar of extra principal removes all the future interest that dollar would have generated for the remaining term.
The formula, and what each part does
The repayment comes from the standard amortisation formula: M = P × [r(1+r)ⁿ] ÷ [(1+r)ⁿ − 1], where P is the amount borrowed, r is the monthly interest rate (the annual rate divided by twelve) and n is the number of monthly payments.
The formula solves for a payment that exactly clears the loan over n periods while charging interest on the declining balance. Every lender in the world uses it for a standard principal and interest loan, which is why a calculator can reproduce a bank's repayment to within a few cents.
The few cents of difference come from real-world details: most lenders accrue interest daily and debit monthly rather than applying a clean monthly rate, months have different lengths, and fees may be bundled into the payment. None of that changes the shape of the curve.
Why a small rate difference costs so much
Interest compounds against you over the full term, so rate differences that look trivial per month are enormous in total. On a $500,000 loan over thirty years, moving from 6% to 6.5% raises the repayment by about $160 a month. And total interest by roughly $57,000.
That is the arithmetic behind refinancing. If a competitor offers half a percentage point less and the switching cost is a few thousand dollars, the payback period is usually under a year on a large loan. Lenders rely on inertia, and the discount available to a customer who threatens to leave is often available simply for asking.
The same arithmetic applies to term. A thirty-year loan at 6% costs about $579,000 in interest; the same loan over twenty years costs about $360,000, at a repayment roughly $580 a month higher. Shorter terms are dramatically cheaper in total and correspondingly harder to service.
Extra repayments, offset accounts and redraw
An extra repayment reduces the principal immediately, so it saves every future interest charge that principal would have attracted. On the $500,000 example, an extra $200 a month cuts roughly four and a half years off the loan and saves over $100,000 in interest. Earlier extra payments are worth far more than later ones.
An offset account achieves the same thing without locking the money away. The balance in the offset is subtracted from the loan balance before interest is calculated, so $50,000 sitting in an offset against a 6% loan saves $3,000 a year. Equivalent to a risk-free, tax-free return of 6%, which is better than most savings accounts after tax.
Redraw looks similar but is not identical. Extra repayments made into the loan can usually be pulled back out, but the lender controls access, can change the terms, and for investment properties redrawing for personal use can change the deductibility of the loan. An offset keeps the money clearly separate, which is why it is generally preferred for an investment loan.
Fixed, variable and the honest trade-off
A fixed rate buys certainty for a period, usually one to five years. A variable rate moves with the market and generally comes with more flexibility: unlimited extra repayments, a full offset account, and no break costs.
Break costs are the part people underestimate. Exiting a fixed loan early, whether to refinance or because you sold, can trigger an economic cost calculation running into thousands or tens of thousands, depending on how rates have moved. Fixed loans also frequently cap extra repayments.
The split approach, fixing part of the loan and leaving the rest variable, is common precisely because it hedges the decision. Fix enough that a rate rise will not break the household budget; leave enough variable that offset and extra repayments still work.
What the repayment leaves out
A mortgage calculator tells you the repayment, not the cost of owning. Rates, insurance, strata levies, maintenance and, in Australia, potentially lenders mortgage insurance all sit on top. A widely used rule is to budget one per cent of the property's value a year for maintenance, which on an $800,000 home is $8,000.
Lenders mortgage insurance applies when borrowing more than eighty per cent of the property value, and it protects the lender rather than you. It can add tens of thousands to the loan, usually capitalised into it so you pay interest on the premium for decades.
The honest affordability test is whether the full cost of ownership fits your budget at a rate two or three percentage points above today's, not whether the current repayment fits. That is roughly the buffer lenders apply themselves when assessing serviceability, and it exists because rates move.
Questions people ask
- Why is so much of my early mortgage payment interest?
- Interest is charged on the outstanding balance, which is at its highest at the start. The fixed repayment covers that interest first, leaving only a small remainder to reduce the principal. As the balance falls, the interest charge falls with it and more of each identical payment goes to principal. Which is why the curve accelerates late in the term.
- Is it better to make extra repayments or use an offset account?
- Financially they are almost identical: both reduce the balance interest is calculated on. An offset is usually preferred because the money stays accessible and, for an investment loan, it avoids the deductibility problems that redrawing can cause. Extra repayments win if you would otherwise spend the money sitting in the offset.
- Should I choose a 15-year or 30-year loan?
- A shorter term costs far less in total interest but requires a much higher repayment. A useful middle path is to take the thirty-year loan for the lower committed repayment and voluntarily pay it like a twenty-year loan. You get most of the interest saving while retaining the ability to drop back if your circumstances change.
- How much does a 0.5% rate difference actually cost?
- On a $500,000 loan over thirty years, moving from 6% to 6.5% adds roughly $160 a month and about $57,000 over the life of the loan. That is why asking your lender for a discount, or refinancing, routinely produces a better return per hour of effort than almost any other household financial task.
- What is lenders mortgage insurance and can I avoid it?
- It is insurance protecting the lender, not you, charged when you borrow more than eighty per cent of the property value. You avoid it with a twenty per cent deposit, a guarantor, or in some cases a government guarantee scheme. Because the premium is usually added to the loan, you pay interest on it for the full term.
Sources
- ASIC Moneysmart: home loan calculator and guidance. Independent Australian guidance on home loans and repayments