How loan interest really works: a worked example
Most people compare loans by the monthly payment. That number matters, but it hides the figure that usually matters more: how much interest you pay over the whole loan. This guide walks through where the interest comes from, using one example you can check yourself in the loan payment calculator.
Where the monthly payment comes from
A standard fixed-rate loan is repaid in equal monthly instalments. Each instalment has two parts. The first part pays the interest that built up on the balance during the month. The second part reduces the balance, which is called the principal.
Because interest is charged on the remaining balance, the first payments are mostly interest. As the balance shrinks, the interest part gets smaller and more of each payment goes to principal.
A worked example
Take a $250,000 loan at 6.5% a year. The monthly interest rate is 6.5% รท 12, which is about 0.54%. In month one, the interest is about $1,354. The payment is about $1,580, so only about $226 reduces the balance. By the last year of a 30-year loan, almost the whole payment is principal.
| Term | Monthly payment | Total interest |
|---|---|---|
| 30 years | about $1,580 | about $318,861 |
| 15 years | about $2,178 | about $141,998 |
What a shorter term really changes
Choosing 15 years instead of 30 raises the monthly payment by roughly $600, but cuts total interest by more than half. Two things cause this: you borrow the money for fewer months, and shorter loans often carry lower rates.
Three ways to pay less interest
- Pick the shortest term you can comfortably afford each month.
- Make extra payments toward principal when you can. Check first that your lender does not charge a penalty.
- Compare offers by APR and total cost, not only by the monthly figure.
What the estimate leaves out
These numbers cover principal and interest only. Fees, insurance, property tax and variable rates change the real cost. Use the result to compare options, then confirm the details with your lender.