Interest structures and loan fees explained

Three questions behind every price

When a lender quotes a loan, the headline rate answers only one of three questions. The second is how and when the interest is collected. The third is which fees sit alongside it. Two offers with an identical rate can cost very different amounts once those other answers are taken into account, and on a short property loan the gap can be wide. This lesson works through each part in turn so you can read an offer as a whole.

Nothing here is a view on whether a particular structure fits your situation. It explains how each one generally works and what to ask.

How interest can be collected

Serviced interest

With serviced interest, you pay interest as it falls due, usually monthly, from rent, business income, savings or another source. The balance does not grow, because nothing is being added to it. The trade-off is that you need reliable cash flow for the whole term, and the lender will want evidence of where the payments will come from. A missed payment is generally a default under the loan agreement, so the source needs to hold up even if a tenant leaves or trading slows.

Capitalised interest

Capitalised interest is added to the loan instead of being paid. Each period the balance rises by the interest charged, and the following period's interest is then calculated on that larger balance, so the effect compounds. This approach is common where the property produces no income until a sale, such as a development or a vacant site. Lenders allow for it when sizing the facility, which means part of the limit is set aside for interest and is not available for the project itself. Capitalising also lifts peak debt, and the lesson on LVR, ICR, DSCR and other ratios shows why that matters to the lender's limits.

Prepaid interest

Prepaid interest, sometimes called retained interest, is withheld by the lender when it pays out the loan. You owe the full loan amount from day one but receive a smaller net sum, and you make no interest payments for the period covered. Because you are effectively borrowing the interest in advance, you may need a larger loan to end up with the cash you actually need. Two points are worth checking: whether any unused amount is refunded if you repay early, and what happens if the loan runs beyond the prepaid period.

Calculation and timing details

Whatever the structure, the loan agreement sets out how interest is worked out and when it is charged. Interest is commonly calculated daily on the outstanding balance and debited monthly, but some private lenders require each month's interest in advance rather than in arrears, which brings the first payment forward. On a construction facility, interest usually accrues only on amounts already drawn, while any line fee applies to the full limit. Check whether the rate quoted is a monthly or annual figure, because private offers sometimes express it per month, and convert both offers to the same basis before weighing them.

Interest-only versus principal and interest

A separate choice is what each repayment covers. On an interest-only loan, payments meet the interest but leave the amount borrowed untouched, so the full principal is due at the end. Most short-term private, bridging and construction loans work this way, because they are designed to be cleared in one amount by a sale or refinance.

A principal and interest loan adds a slice of the principal to each repayment, so the debt shrinks over time. Repayments are larger, but total interest over the life of the loan is generally lower. Longer-term commercial and residential loans often use this structure, sometimes after an initial interest-only period. The repayments calculator shows how the two compare for a given amount, rate and term.

Fixed, variable and default rates

A variable rate can change during the loan, often moving broadly with lenders' funding costs, which the Reserve Bank's cash rate target influences. That target is currently 4.6%^[1], and the cash rate page tracks it. A fixed rate stays the same for an agreed period but can bring break costs if the loan ends early.

Default interest is a higher rate that applies when the borrower is in default, such as after a missed payment or when the loan is not repaid at expiry. Some private loan agreements express this the other way round, quoting a higher rate and allowing a lower one only while payments are on time. Read how the agreement describes it, because the practical effect is the same.

The fees, one at a time

• Establishment fee. Charged when the loan is set up, sometimes calculated on the facility limit and usually deducted from the first advance. A broker's fee may be charged separately on top.
• Line fee. Charged on the whole committed limit rather than the drawn balance, typically in construction or revolving facilities where funds are drawn in stages.
• Extension fee. Payable if the lender agrees to extend the term. Extensions are usually at the lender's discretion and may come with a new rate, an updated valuation or other conditions.
• Exit fee. Payable when the loan is repaid, either at any time or only on early repayment. Some agreements also set a minimum interest period, which has a similar effect. For regulated consumer credit, the law restricts certain early repayment charges, so ask the lender how its terms comply.
• Break costs. Apply when a fixed-rate loan is repaid or varied during the fixed period. They are calculated from market rates at the time, so they cannot be known exactly in advance.
• Third-party and enforcement costs. Valuation fees, the lender's legal costs, title searches and registration fees are commonly passed on, and enforcement costs are usually recoverable from the borrower if a default occurs.

A worked description in words

Imagine a hypothetical builder holding two offers for the same short-term loan. The first has a lower rate, but interest is prepaid for the full term and an exit fee applies. The second has a higher rate, serviced monthly, with no exit fee and a smaller establishment fee. On rate alone the first looks cheaper. Once the prepaid interest is added to the borrowing, the exit fee is included and the builder tests a scenario where the sale takes longer than planned, the comparison may look quite different. Entering both offers into the loan cost estimator over the expected term, and again over a longer one, shows the overall cost of each and how sensitive it is to delay.

Common mistakes

• Judging an offer on its rate without adding fees and the effect of the interest structure.
• Forgetting that prepaid interest and deducted fees reduce the cash that actually reaches you.
• Assuming capitalised interest is free because nothing is paid during the term.
• Overlooking the cost of a line fee on funds that will not be drawn for months.
• Not asking what happens to the rate and fees if the loan needs an extension.

What to ask before accepting an offer

1. Is interest serviced, capitalised or prepaid, and is unused prepaid interest refunded?
2. Is the loan interest-only, and what happens to repayments at the end of any interest-only period?
3. Which fees apply, how is each calculated, and which are deducted at settlement?
4. Is there an exit fee, early repayment fee or minimum interest period?
5. What default interest applies, and what triggers it?
6. If the rate is fixed, how are break costs calculated?

The lesson on reading a term sheet shows where these terms usually appear in an offer.