Why Early Repayments Are Almost All Interest

Key takeaways

• Interest is calculated on the balance, which is largest at the start.
• The first repayment on a 30-year loan is typically 80%+ interest.
• Principal overtakes interest around the 18-year mark on a 30-year term.
• An extra dollar repaid in year one saves far more than the same dollar in year 20.

What does the split look like over time?

Illustrative: $600,000, 6.00% p.a., 30 years, principal and interest, repayment $3,597 per month.

The crossover - the month where principal first exceeds interest - falls between years 18 and 19. Over the full term this loan pays about $695,000 in interest on $600,000 borrowed.

Why does it work this way?

Because the repayment is fixed and the interest component is not. Each month the lender charges interest on whatever is outstanding, and the rest of your payment reduces the balance.

In month one the balance is the full $600,000, so at 6% the interest is $3,000. Whatever is left of the $3,597 payment - $597 - comes off the principal. Next month the balance is $597 lower, so the interest is very slightly less and the principal component very slightly more.

That process compounds, slowly at first and then quickly. It is the same mechanism as compound interest running in reverse, which is why the curve is flat for years and then steepens sharply.

What does this mean for extra repayments?

That timing dominates amount. An extra dollar paid in year one removes a dollar of balance that would otherwise have accrued interest for 29 more years. The same dollar in year 25 avoids only five years of interest.

On the loan above, an extra $500 a month from the start would take years off the term and save a substantial share of that $695,000 - and the earlier it starts, the larger the effect. Run the numbers on your own loan with your lender's calculator rather than relying on a general figure, because your rate and remaining term change it.

Three practical implications:

• Front-load if you can. The first five years are where extra repayments do the most work.
• An offset achieves the same thing with the money still accessible, which is usually better for a household that may need the funds.
• Fortnightly repayments help largely because paying half the monthly amount every fortnight results in the equivalent of thirteen monthly payments a year, not because of any interest-calculation trick.

Frequently asked questions

Why is my first mortgage payment nearly all interest?

Because interest is charged on the outstanding balance, which is at its maximum at the start. On a 30-year loan at typical rates, over 80% of the first repayment is interest and only a small fraction reduces the principal.

When does principal overtake interest?

On a 30-year loan at around 6%, roughly between years 18 and 19. The crossover comes earlier at lower rates or shorter terms, and later at higher rates.

How much interest will I pay over 30 years?

On $600,000 at 6% over 30 years, approximately $695,000 - more than the amount borrowed. The total is highly sensitive to the rate and the term, so run your own numbers.

Is it better to make extra repayments early or later?

Early, substantially. An extra dollar repaid in year one avoids interest for the remaining 29 years; the same dollar in year 25 avoids only five years of interest.

Related reading

• Amortisation Schedules: Reading Your First 12 Months
• Lump Sum vs Extra Repayments: Which Saves More?
• Offset Account Maths: Dollar-for-Dollar Savings Modelled

Sources

• Moneysmart mortgage calculator — ASIC
• Statistical tables - lending rates — Reserve Bank of Australia