Q13: How does my home loan work?

For most people, a home loan is their biggest financial commitment. It’s worthwhile to learn how it works

Over one third of all Australians have at least one home loan. For just about all of those people this is the largest loan they’ll ever have to repay and it’s a loan over an asset which is vitally important to them and their family: it’s the house they live in. Understanding how a home loan works is important since it’s such a big part of many people’s lives and more knowledge can take away much of the stress that goes along with such a large borrowing.

A home loan is also called a mortgage. This word comes to our language via old French and it literally means “death pledge”. English lawyers in the Middle Ages used this term to describe an arrangement where a loan was given to a person who pledged an asset as collateral for the loan.  In the case of a home loan you are pledging to the lender a claim on the house and land you want to buy as security on the loan. The pledging arrangement will end when either the loan is repaid in full or the borrower defaults and the lender takes possession of the house and land; the “death” referred to is not your death but the ending of the loan contract.

Just like any other loan the lender will charge an interest rate on the amount you borrow. Most home loans in Australia are what are termed “principal and interest” loans. This means that the repayments you make will pay off all the interest accrued in each period (usually monthly) and a part of the principal, or original loan amount. This continues until the loan is fully repaid. The bank is able to calculate the regular, fixed payment amount that will pay off your loan over the term you agreed to at the prevailing interest rate.

I’ve created an Excel spreadsheet which I’ll use to explain how a principal and interest home loan works and how — if you can afford it — paying extra can save you a lot of money and shorten the time it will take to pay off your loan. You can download the spreadsheet here: YourMortgage.

You’ll remember from an earlier post that compound interest is a powerful force that can, over time, greatly increase your wealth. This is because time and the compounding effect of interest work together to give you interest on interest which grows at an increasing rate. This is true when you are the investor. Unfortunately compound interest cuts both ways and when you’re the borrower the power of compounding is working against you. The more you borrow, the longer you take to repay it and the higher the interest rate that’s being applied to your loan the more you’re hurt by compounding interest.

Let’s take a look at our spreadsheet. The calculations are loaded with a $1,000,000 loan over 30 years at 3.99%. The monthly repayment for this loan will be $4,768. After 360 monthly payments the loan will be completely repaid (assuming that the interest rate does not change). You can also see that over the 30 years of your loan you’ll pay $716,619 in interest. Ouch! You can change the rate and see what effect this has on the loan repayments to get a feel for how the payment fluctuates. You can also use this to figure out your budget for either how much of a loan you can afford and at what level of interest rate your payments make your household budget too tight to manage comfortably.

Before you take out a home loan it’s good practice to do some stress-testing on your budget to make sure that you’re not biting off more than you can chew. Thirty years is a long time and during that period interest rates could fall or rise. In mid-1989 interest rates on Australian home loans reached 17% and while there’s no indication at present that interest rates could rise to that level, you can’t be sure what the future might hold. Type in some rates up to 5% higher than currently available and see how affordable your loan becomes. Remember also that many new home loan borrowers are young adults who may want to start a family. Can you afford your loan on one income? Can you afford your home loan with extra mouths to feed?

Now turn your attention to the charts. One shows how the balance outstanding on your loan falls over time. This is because each time you make a payment you’re paying off the accrued interest for the month, plus an increasing amount of the principal. As each payment chips away slightly at the principal, the interest accruing each month is slightly less. Since the payment amount is fixed, each month you’re paying interest on a lower principal, and the rate of decline in the principal actually increases over time. You can see that the line starts to dip slowly then falls faster and faster.

If you scroll down you can see a chart showing that the proportion of each payment which is a principal repayment increases: when you make your first repayment about 30% of it is a repayment of the loan while the other 70% covers the interest. After just over 12 years the ratio is 50:50 until, by the end of the loan, the last payment is about 99.7% principal.

This process is called amortisation and, coincidentally, it’s from the same Latin origin as mortgage (the mort part means “death”, hence mortuary, mortal, mortify, morbid) and it refers to the loan principal dying (reducing) over time.

Our spreadsheet has another part which is where we can see how we have the opportunity to slay the compound interest dragon, or at least to give it a good kick in the shins. With a home loan you have the opportunity to pay more than your required monthly payment. These extra payments can have a significant effect on the time it takes to pay off your loan and the amount of interest you’ll pay. We’ll use our initial example of a 30 year, $1 million loan at 3.99% and then make an extra monthly payment of $500 every month (we’ll also assume that the additional payment is made at the same time as the regular payment to make the maths a bit easier). If you type that amount in to the spreadsheet you will see the charts change: a new line will appear showing the course of the loan with the additional payment included. Our loan is now paid off in just over 25 years: we’ve saved 4.9 years of home loan payments and $133,806 in interest payments. Just by finding an extra $125 each week we will be debt-free sooner and make a huge saving. You could invest that saving and then have compound interest working for you instead of against you. You can type other numbers in there to see what effect higher or lower additional payments make.

Because the original loan was structured with a principal and interest repayment, any additional payments go directly to reducing the principal amount of the loan and immediately reduce the loan and the interest accruing on it. This is the best part about making extra repayments: when we make extra payments we’re snatching our money back from the bank by reducing the interest we’re being charged. So not only can you feel good about owning your home earlier you can also get the satisfaction of keeping your money out of the bank’s hands. It’s a winning strategy… for you.

For those of you who are interested in seeing the loan amortisation process operate on a month-by-month basis and the maths behind it you can take a look at the Amortisation sheet in the spreadsheet. This shows our original loan schedule and the extra payments schedule. You can see how, for any loan, the monthly repayment amount is fixed at the start so that the loan is paid off in the time allowed and how interest accrues from the start of each month on the reducing loan balance. This works through, as we discussed earlier, to the payment being against a larger proportion of the loan balance each month as the principal is amortised each month.

These examples show how a home loan works, how amortisation plays out and the benefits of making extra payments. I don’t suggest that any of this is financial advice or that you should follow any of the examples discussed. The main takeaway is a better understanding of how your home loan operates and the potential benefits of making extra payments on your loan. Even a one-off payment from a bonus, inheritance or lottery win can make a substantial dent in the time it takes to pay off your house and the amount of interest you’ll end up paying. The Latin word for “death” appears a lot in the home loan world; you can use your knowledge of the repayment process to kill off your loan and own your home faster.