How loan payments are calculated
Most auto loans, personal loans and private student loans are amortizing installment loans. You pay the same amount every month, and each payment first covers the interest that built up that month. Whatever is left goes to the balance.
Here P is the amount borrowed, r is the annual rate divided by 12 and n is the number of monthly payments. Because interest is charged on the remaining balance, early payments carry the most interest. That is also why paying extra early has such a large effect.
Worked example
Borrow $25,000 at 7.9% for 60 months and the payment is $505.71. In the first month, $164.58 of it is interest. Over five years you pay $5,342.85 in interest, for a total of $30,342.85.
Add $100 a month and the loan is gone in 49 months instead of 60, saving about $1,074.08 in interest.
Tips before you borrow
- Compare the total cost, not just the payment. A longer term lowers the payment but adds interest.
- Check for prepayment penalties. Most auto and personal loans have none, but read the agreement before paying extra.
- Tell the lender where extra money goes. Ask for it to be applied to principal, not held toward next month's payment.
- Watch for fees. An origination fee taken from the loan means you receive less than you borrow. If a fee is added to the loan, add it to the amount here.