Fri Sep 22

Why you're probably paying more interest on your mortgage than you think

Written by: Sander De Groote, Lecturer, School of Accounting, Auditing and Taxation, UNSW Sydney

For most things we buy, the price we are quoted is the price we pay.

That’s supposed to be the case even where taxes and fees are involved. Australian law requires anyone selling anything to display a total price ^[1] that includes all “taxes, duties and all unavoidable or pre-selected extra fees”.

But our investigations, which compare the interest rate quoted on our mortgages with the fine print in our own mortgage documents, shows this is hardly ever the case for home loans.

Even though we are both trained as accountants, until recently we hadn’t bothered to check – even as interest rates climbed. We assumed the rates we were being told we were being charged (say 5% per year) were the rates we were actually paying.

This would be easy enough, and in our view the right thing, for banks to do.

The price quoted usually isn’t the price paid

Mortgage interest is usually charged monthly, but the rates are yearly. This means that each time interest is charged, the outstanding amount compounds ^[2] as interest is applied to interest.

That sounds bad enough. But this isn’t our main complaint.

It’s that there are two possible ways to calculate the amount of interest. Banks calcualte interest on a daily basis.

The most reasonable would be to calculate the daily amount in a way that adds up to an annual amount that matches what was quoted. That way, a 5% rate would really be 5%.

Although there’s a bit of calculation ^[3] involved, it’s easy enough for banks to do.

How banks calculate mortgage interest

The other, arguably less reasonable, way is what’s called the “simple ^[4]” method. Our investigations show that this technique is used by all the big four banks, and probably many others too.

It’s called the simple method because it involves simply dividing the annual rate (say 5%) by 365 to determine the daily rate.

This seems to not be important, but because of compounding it means the amount charged over a year is more than the rate quoted.

Say you borrow $100,000 for one year at an annual rate of 5%, repaying the whole amount at the end of the year.

You might expect to pay back $105,000. Instead, the banks’ method of calculating interest results in a total repayment of $105,116.

This is because the daily interest rate (5% divided by 365) is applied to the outstanding balance each day and added to your balance once a month. These regular increases mean your interest compounds costing you more.

Over decades, the difference matters

In July 2023, the average size of a new mortgage in New South Wales was about A$750,000, with an average interest rate of about 5.95%.

$27,000 over the life of a 30-year loan. Shutterstock

The method of calculation used by the banks and in the fine print of their mortgage contracts requires a monthly payment of $4,473 including the repayment of the amount originally borrowed over the life of a 30-year loan.

But if 5.95% were actually charged each year, the monthly payment would be $4,398 – a difference of $900 per year.

In this typical example, the difference over the life of the loan amounts to about $27,000. It means these borrowers will end up paying an effective interest rate of 6.11%.

We had to read the fine print

We checked the terms and conditions of each of the big four banks – Westpac, the Commonwealth, the National Australia Bank and the ANZ – as well as their biggest subsidiaries which include St George, The Bank of Melbourne, Bank SA and Bankwest.

They all charge interest using the “simple” method.

Mutual banks – the old credit unions and building societies owned by their members – have different reporting requirements, and we were unable to check the terms and conditions used by each one. But where we could, we found they used the same method as the big four.

You can find this small print yourself, usually in the middle of your mortgage document. It’s a formula, accompanied by a paragraph of explanation.

But you have to look carefully. Or you could call customer service, as we did, and ask the bank to explain the calculation.

You shouldn’t have to.

The price quoted ought to be the price paid

We think the price quoted for a product should be the price that’s actually charged, as the law generally requires ^[6] for products other than mortgages.

This means if you are told you’ll be charged 5.95% interest per year, you should pay 5.95% per year – not 6.11% because of a quirk in the formula.

Mortgages are a larger financial commitment than most purchases. This means that honesty and clear communication are even more important.

It’s worth knowing what you are letting yourself in for when signing up for a mortgage. That way, when the bank or broker explains it to you and it’s not what was advertised, you can ask for a discount.