How loan interest really works

When you borrow money, you pay for the privilege. That price is interest, and it is worth understanding how it is charged, because a few simple facts explain why two loans with the same monthly payment can cost very different amounts overall.

Interest is charged on what you still owe

Each month your lender looks at the remaining balance, applies the monthly rate, and that is the interest for the month. If you owe $20,000 at 6% a year, the monthly rate is 0.5%, so the first month's interest is $100. Your fixed payment is $386.66, so $286.66 of it goes to paying down what you borrowed.

The next month the balance is a little lower, so the interest is a little lower, and slightly more of your payment goes to principal. This slow shift is called amortisation.

What the first and last years look like

In year one, a large share of your payments is interest. By the end it is very small. That is why paying extra early is powerful: it removes principal while the balance, and so the interest, is highest.

Term length changes the total cost

A longer loan has a smaller payment, which feels friendlier, but you are charged interest for more months.

Stretching from 3 to 7 years drops the payment by more than $300 a month but costs about $2,640 extra in interest.

Interest rate versus APR

The interest rate is the plain cost of borrowing. The APR (annual percentage rate) adds certain fees to give a fuller picture, so it is the better number for comparing offers. Always compare APR to APR.

Ways to pay less

• Choose the shortest term you can comfortably afford.
• Pay a little extra each month. Even $25 extra shortens the loan and cuts interest.
• Check for early repayment fees before you plan to overpay.
• Compare total cost, not just the monthly figure.