Understanding How Lenders Calculate Mortgage Interest on Loans


Interest is a fundamental component of borrowing money, influencing the total cost of a loan and affecting borrowers’ monthly payments. But how do lenders calculate interest on a mortgage, and what factors influence the final amount borrowers pay? Let’s delve into the intricacies of interest calculation to gain a deeper understanding of how it works. 

The Basics of Interest 

Interest is essentially the cost of borrowing money, expressed as a percentage of the loan amount (principal). Lenders charge interest to compensate for the risk they assume when lending money and to generate profit from the transaction. 

Simple Interest vs. Compound Interest 

There are two primary methods of interest calculation: simple interest and compound interest. Most mortgages, for example, are compound interest, especially in Australia. 

Simple Interest 

  • With simple interest, the interest is calculated only on the initial principal amount. Each period, typically defined as a month, the borrower pays a fixed amount of interest based on the original principal. The total interest paid over the life of the loan remains constant. 

Compound Interest 

  • Compound interest, on the other hand, involves calculating interest not only on the initial principal but also on the accumulated interest from previous periods. This results in the interest compounding over time, leading to a higher total interest cost compared to simple interest. With compound interest, it’s best to make payments as frequently as possible to keep a lower interest rate. This is how mortgage interest is calculated in Australia. 

Factors Influencing Interest Rates 

Several factors influence the interest rate borrowers are charged, including: 


  • Lenders assess borrowers’ creditworthiness, primarily through credit scores and credit reports, to determine the risk of default. Borrowers with higher credit scores typically qualify for lower interest rates, reflecting lower perceived risk to lenders. 

Loan Term 

  • The term of the loan, or the length of time borrowers have to repay it, can impact the interest rate. Generally, longer loan terms tend to have higher interest rates to compensate for the extended repayment period. 

Economic Conditions 

  • Lenders consider prevailing economic conditions, including inflation rates, market trends, and central bank policies, when setting interest rates. Economic factors influence lenders’ cost of funds and their willingness to lend at certain rates. 

Type of Loan 

  • Different types of loans, such as fixed-rate mortgages, variable-rate mortgages, and personal loans, may have varying interest rate structures. Fixed-rate loans maintain a constant interest rate throughout the loan term, while variable-rate loans’ rates typically fluctuate based on market conditions. 

In addition to Interest Rates 

As you can see, looking at the interest rate can give you an idea of the cost of the loan, but it certainly doesn’t tell the full story. Instead, here are a couple of additional factors to consider that can give a clearer picture when considering the interest rate: 

Comparison Rate 

  • The comparison rate is similar to the interest rate, however it also takes into account the fees and charges associated with the loan outside of interest, giving you a more complete picture of the cost of the loan. 

Annual Percentage Rate (APR) 

  • The APR represents the total cost of borrowing over a year, including interest and certain fees. It provides borrowers with a standardised way to compare loan offers from different lenders. This may not be advertised alongside the rate by the lender, so you may need to ask them directly or work the APR out with your broker. 

Understanding how lenders calculate mortgage interest is essential for borrowers seeking loans. While it can be a great deal of information to take in and consider when looking to get a loan, it’s important to know that you don’t need to go through the process alone. In fact, more often than not it’s much better to get help from an expert. 


Fortunately, the team at Glass Financial are the only lending and credit experts you will ever need in your corner. Our top priority is helping you get exactly what you’re looking for with no hidden tricks or conditions. 


So give us a call today on 1300 245 277 or send us an email to [email protected]  


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