How loan interest actually works

On a standard amortising loan — a personal loan, car loan or mortgage — interest each month is calculated on the outstanding balance, not the original amount borrowed. Your monthly payment stays the same, but what it's made of changes every single month.

Take a $20,000 loan at 10% over five years. The monthly payment is about $425. In month one, interest is 10% ÷ 12 on the full $20,000 — roughly $167 — so only $258 goes to the principal. By the final month, interest is a couple of dollars and almost the whole payment clears the debt.

This is the single most misunderstood thing about loans. People assume a fixed payment means fixed progress, and then wonder why, three years into a five-year loan, they still owe far more than 40% of what they borrowed.

An extra payment goes entirely against principal. It doesn't just save you that month's interest — it reduces the balance that every remaining month's interest is calculated on, for the rest of the loan.

On that same $20,000 loan, paying an extra $50 a month cuts roughly nine months off the term and saves around $900 in interest. You paid an additional $2,500 over the life of the loan and got $900 of it back as interest you never had to pay, while finishing early.

The effect is strongest at the start, for exactly the reason above: an extra payment in month one avoids interest on that amount for 59 subsequent months. The same payment in month 55 avoids it for five.

Some lenders quote a 'flat rate': interest calculated on the full original principal for the entire term, regardless of how much you have already repaid. It is legal, it is clearly disclosed in most jurisdictions, and it is roughly twice as expensive as it sounds.

A 10% flat rate on $20,000 over three years means $6,000 of interest — 10% of $20,000, three times. But you don't have $20,000 for three years; by the end you have almost none of it. The equivalent reducing-balance rate is close to 18%.

The rule of thumb: a flat rate is approximately equivalent to a reducing-balance rate of just under double, for terms of a few years. If a quote uses the words 'flat', 'fixed on the original amount', or gives you a total interest figure without a rate, ask specifically for the effective annual percentage rate before comparing it with anything.

Lenders are usually happy to lower your monthly payment by extending the term, and it is presented as a favour. It is a favour to your cash flow and a substantial cost to your total.

The same $20,000 at 10% costs about $3,232 in interest over three years, $5,496 over five, and $7,891 over seven. The monthly payment halves; the interest bill more than doubles. Neither figure is hidden — but only one of them appears in the advertisement.

That doesn't make the longer term wrong. If the shorter term's payment would leave you unable to cover an emergency, the longer one is the correct choice and the extra interest is the price of that safety. The point is to make it a decision rather than a default.

The same mathematics that makes debt expensive makes saving powerful, and it is worth seeing both sides in one place. $10,000 growing at 8% a year becomes about $21,600 after ten years and $100,600 after thirty. The first decade adds $11,600; the third adds $54,000.

The rule of 72 is the quickest way to hold this in your head: divide 72 by the annual rate to get the approximate doubling time. At 8%, money doubles every nine years. It is also a fast way to sanity-check a promise — anyone offering to double your money in three years is implying a 24% annual return, which tells you exactly how much risk is involved.