Repayments vs. Interest

As a home loan borrower you need to understand the relationship between repayments and interest. While interest forms part of the repayment the repayment can be manipulated by other loan factors such as the loan term.

For example if you have a $100,000 home loan at 7% p.a. and repay the loan over a term of 20 years you will pay $775.30 per month, but if the term were extended to 30 years your repayment would reduce to $665.30. Note the interest rate remains the same in both scenarios.

Some mortgage sales people would say you have saved $110 per payment! But what about the total repayment amount and total amount of interest paid? In the first scenario where your repayment is $775.30 if you were to only make the minimum repayment for the full 20 year term you would repay $186,072.00, of which $86,072 is interest. In the second scenario where you pay the loan off over 30 years but have reduced repayments, you would end up paying $239,508! That’s $53,436 higher than the first scenario and you end up paying the bank $139,508 in interest! That is definitely no saving.

The simplest way to understand interest is to remember that as the term of the loan increases or the interest rate goes up, the amount of interest paid increases exponentially.

As we have seen, by extending the term of a $100,000 loan by 10 years increases the total interest paid by more than $53,000. So what would happen if we decreased the term? A $100,000 home loan with a term of 10 years at an interest rate of 7%pa would result in total interest change of $39,330 a reduction of almost $47,000 on the 20 year term loan! The Repayment does however increase to $1,161.

I admit must people will not repay their home loan off in 10 years but it’s a good point to remember, simply put the more you pay now the better off you are in the long run.