How do Banks calculate interest?

Home loan rates are shown as an annual rate but are divided by 365 to get a daily rate (use 366 for a leap year). The daily rate is then applied to the loan balance each day. Assume a $350,000 loan with an interest rate of 4.50%. Figures are rounded for ease of understanding.

Loan Balance X (Annual Rate/365) = Daily Interest
$350,000 X (4.50% / 365) = Daily Interest
$350,000 X 0.0123287% = Daily Interest
$43.15 = Daily Interest

This calculation is done every day. At the end of a 30 day month, the total $1,294 is debited to the loan so the balance becomes $351,294.

Usually on this day the monthly payment of $1,774 is made and the loan balance starts day 1 of the next month at $349,520 and the process starts again.

$349,521 X 0.0123287% = $43.09

The same calculation applies regardless of whether the loan is a fixed or variable rate. If the loan settles on say 13th of the month, it is the number of days until the 13th of the next month and so on.

Understanding this process is critical in deciding which loan features (redraws, offsets) and repayment options (weekly, fortnightly, monthly) work best.

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