How can I structure my mortgage to lower interest payments?

There are up to 26 different features or attributes that define the structure of a mortgage. That means there are up to 26 decisions that you will either make or have made that directly affect the financial cost of your mortgage, the safety it affords you and how much stress and time it takes to manage your loan.

Although it’s tempting to focus on interest rates as a starting point for comparing your mortgage options, an interest rate quoted on a website, in a magazine, newspaper or over the phone could be the nominal rate, headline rate, intro rate, or comparison rate. Each is different and each includes a different, incomplete set of fees that the lender will or is likely to add to your loan.

More importantly, a loan with a seemingly higher interest rate and better structure could actually be more cost-effective than a lower rate but with high fees. 

The good news is that you can structure your loan without employing clever tricks or questionable strategies sometimes promoted by lenders and brokers alike. However, you do need to understand the structure decisions you will make when taking out your mortgage.

1. Choose an appropriate loan term

Loan term refers to the number of years it takes to repay your mortgage assuming you only ever make the minimum monthly, fortnightly, or weekly repayments. In recent years, as borrowers take on larger and larger loans, terms have stretched beyond the rather old-fashioned loan term of 20 years.

Although terms of 25 years were common a few years ago, 30 years seems to be the new 25 and some lenders are even encouraging terms of 40 years. 

Lenders and mortgage brokers alike may encourage you to take your mortgage over a longer loan term. As a general guide, the decision to stretch your loan from 25 to 30 years reduces your repayments by just 6%, however, it increases your interest cost by 25% (based on a 15-year average of competitive rates, which is around 7.09% p.a.).

This means stretching your term from 25 years to 30 years for a $300,000 mortgage lowers your monthly repayment by just $124 a month, however, it will cost you almost $84,000 in extra interest.

As a general rule, consider taking the shortest possible term that delivers a payment amount that you feel is manageable. This payment amount should provide you with adequate protection against possible rate increases.

Don't forget, too, that a bank will assess your ability to repay on what's called a serviceability buffer. This is usually calculated on APRA's buffer, or the bank's own floor rate. For example, if you have a mortgage rate of 4.00% p.a. your bank could assess your ability to repay on around 7.00% p.a.

A mortgage payment of 30% or more of household income is generally considered 'mortgage stress'.

25 vs 30 Year Mortgage - Cost Breakdown

Based on an advertised home loan rate of 4.00% p.a.

2. Pick your payment type

There are two payment types available, Principal and Interest (P&I), and Interest Only (IO). Interest is the main fee lenders charge for use of borrowed money. Principal is the debt – the actual money you have borrowed.

P&I is where you are required to repay a part of your debt with each regular payment as well as the interest for that period. IO, as the name suggests, means you are not required to pay off any part of your debt, you simply pay the interest for that period.

IO payments are lower as they do not include the additional amount to help repay your debt. However, what many people overlook is that you have a larger debt for longer, which means you will pay more interest in the long run. Think of it as kicking the can down the road.

Many IO periods typically last for five years, and sometimes come with the ability to extend for a further five. If your loan switches to P&I after a certain period then your P&I payment will also be higher than if you took P&I from the very beginning, because you have a shorter time to repay the debt.

The most common reason for choosing IO is that it reduces your minimum payments. This is usually pitched at investors - backed by the friendly reminder that interest is tax deductible. This allows them to find tenants, reduce their monthly repayments to zero or near-zero after tax deductions, and then sell the property later for a profit.

See the latest interest-only home loans here: Compare interest only home loans

IO vs P&I: How much extra interest you pay

Based on a mortgage rate of 4.00% p.a. on a 30-year term, IO period of five years.

3. To fix or not to fix?

Like many of the decisions around structure, you only really have two options when it comes to rate type, which are either a variable or fixed. As their names suggest, variable rates will go up and down from time to time, fixed rates won’t although, keep in mind that all fixed rates will turn into variable rates at the end of your fixed rate period.

Generally speaking, fixed rate types will wind up costing you more as the interest rates are generally higher, and will keep you locked in to your lender. However, they also provide you with more security and better control of your money, as you know for certain how much your payment will be each month during the fixed rate term.

If you are not quite ready to fix, consider staying variable, increase your payments while rates are low, which get you used to paying higher repayments should interest rates rise. Extra repayments increase your equity, creating a redraw buffer for a rainy day. On the other hand, fixed loans typically limit extra repayments to $10,000 per year.

How about a split?

A third option is to take your loan part fixed, part variable. If you are not sure whether to fix your rate, lenders and some brokers are likely to suggest half-fixed and half-variable. The reassuring advice is ‘you get the best of both worlds’, to paraphrase Hannah Montana.

However it might be the lender and the broker who get the best of both worlds, not you. To look at it with a glass-half-empty, the fixed half, which is often at a higher rate, anchors your whole loan with them no matter how well they look after you. It strips away your flexibility to vote with your feet. At the same time, if rates increase, your repayments also increase. This strips away repayment certainty, which is the the most distinct advantage of a fixed rate loan.

Article first published November 2017, last updated by Harrison Astbury July 2022.