Home Loan Basics: How Mortgages Actually Work

How a repayment splits between principal and interest

A standard principal and interest (P&I) home loan uses a fixed repayment amount that covers both the interest charged that period and a portion of the original loan (the principal). What changes over the life of the loan is the split between the two, not the repayment amount itself.

Early in a 30-year loan, most of each repayment is interest, since interest is calculated on the outstanding balance, which is still close to the full loan amount. As the balance falls, less interest accrues each period, so more of the fixed repayment goes towards principal. On a $600,000 loan at 6%, the first year's repayments are roughly 85% interest and 15% principal. By year 20, that ratio has largely reversed.

This is why paying off a mortgage feels slow at first and faster later on, the principal balance genuinely falls faster in the back half of the loan.

Fixed vs variable rates

A variable rate moves with the lender's own rate decisions, which are influenced by the RBA cash rate. Repayments can rise or fall over the loan term. Variable loans typically come with full flexibility: offset accounts, redraw, and unlimited extra repayments.

A fixed rate locks in the interest rate for a set period, usually one to five years, giving repayment certainty. In exchange, fixed loans commonly restrict extra repayments to a capped amount per year and often do not offer a full offset account. Breaking a fixed term early to refinance or sell can trigger a break cost, which is larger when market rates have fallen since the loan was fixed.

A split loan, part fixed and part variable, is a common middle ground: the fixed portion gives some repayment certainty, while the variable portion retains offset access and unrestricted extra repayments.

Interest-only loans

An interest-only (IO) loan requires repayments that cover only the interest charged, with no reduction in principal, typically for a set period of one to five years. Repayments are lower during that period, but the loan balance does not fall, and no equity builds from repayments (only from any property value growth).

IO loans are more common for investment properties, where the interest is tax-deductible and the strategy is often to build equity through capital growth rather than repayment. For an owner-occupier, an IO loan delays equity building and typically costs more in total interest over the life of the loan, since the balance stays higher for longer.

The most important detail with any IO loan is what happens at the end of the interest-only period. Repayments step up to principal and interest, calculated over the remaining loan term, which is now shorter than the original term. This increase is often underestimated and should be budgeted for well in advance.

Loan terms: 25 years vs 30 years

A longer loan term reduces the minimum monthly repayment by spreading principal repayment over more years, but increases total interest paid because the balance stays higher for longer. A shorter term does the opposite.

On a $600,000 loan at 6%, a 30-year term costs roughly $3,600 per month, a 25-year term roughly $3,865 per month, a difference of about $265 per month. Over the full loan life, the 25-year term saves over $135,000 in total interest. The trade-off is a smaller monthly repayment buffer with the longer term versus a larger one with the shorter term.

Many borrowers choose the longer term for flexibility (a lower required minimum repayment gives more room during a rate rise or income disruption), then voluntarily pay at the higher, shorter-term level when they can. This gets close to the best of both: the interest savings of a shorter term with the safety net of a lower contractual minimum.

What extra repayments are actually worth

Extra repayments reduce the principal balance directly, which reduces the interest charged on every subsequent period for the rest of the loan. Because interest compounds against the balance, extra repayments made earlier in the loan are worth more than the same amount made later.

On a $600,000 loan at 6% over 30 years, an extra $200 per month from the start cuts close to four years off the loan and saves roughly $105,000 in total interest. The Mortgage Repayment Calculator models this for any loan amount, rate, and extra repayment figure.

Offset accounts and redraw

Both an offset account and a redraw facility reduce the interest charged using money you already have, but they work differently and are treated differently for tax purposes if the property is ever rented out. A full comparison, including which one suits an investor versus an owner-occupier, is covered in the offset vs redraw guide.

Choosing a structure

• Want repayment certainty: fix all or part of the loan, accepting reduced flexibility on extra repayments.
• Want to minimise total interest: choose variable for offset access, and make extra repayments whenever possible, especially early in the loan.
• Want lower repayments now: a longer term or an interest-only period reduces short-term cash flow pressure, at the cost of more total interest and slower equity building.

Common mistakes

Choosing purely on advertised rate

The lowest headline rate is not always the cheapest loan once fees, offset account quality, and redraw flexibility are considered. A slightly higher rate with a genuine offset account often costs less overall than a lower rate with no offset.

Not budgeting for the interest-only step-up

Borrowers on an interest-only loan sometimes assume repayments will only rise slightly once the IO period ends. In practice the increase is often 30% or more, since the remaining principal is now repaid over a shorter period than originally planned.

Ignoring extra repayments because they seem small

An extra $50 or $100 a month feels insignificant next to a $600,000 loan, but compounded over 25 to 30 years it removes years from the loan term and tens of thousands of dollars in interest. Small, consistent extra repayments made early are worth more than larger ones made later.

Frequently asked questions