How Loan Interest Works: Monthly Payments, APR and Total Cost

Interest is charged on what you still owe

With a standard amortizing loan, the lender charges interest each month on the balance you still owe. The yearly rate is divided by 12 to get a monthly rate. If you owe 10,000 at 6% a year, the first month's interest is 10,000 × 0.06 ÷ 12 = 50.

Your monthly payment covers that interest first, and the rest reduces the balance. Next month the balance is a little smaller, so the interest is a little smaller, and more of your payment goes towards the balance.

How the fixed payment is worked out

Lenders use a formula that finds the one fixed payment that brings the balance to exactly zero at the end of the term: payment = P × r ÷ (1 − (1 + r)^−n), where P is the amount borrowed, r is the monthly rate, and n is the number of months. You don't need to work it out by hand — the Loan Payment Estimator does it for you — but it helps to know that the rate and the term are the two levers.

For example, 25,000 borrowed at 7% for five years gives a payment of about 495 a month. Over 60 months you pay about 29,700 in total, so the interest is roughly 4,700.

Why early payments feel slow

At the start of a loan the balance is at its highest, so interest takes up a large part of each payment. On a 30-year mortgage, the first payments can be more than half interest. This is normal, and it is why extra payments early on can save a lot: every amount paid off the balance stops collecting interest for the rest of the term.

Longer terms cost more

Stretching a loan over more years lowers the monthly payment, but you pay interest for longer. 200,000 at 6% costs about 1,687 a month over 15 years, with about 103,700 in total interest. Over 30 years the payment drops to about 1,199, but total interest more than doubles to about 231,700.

A lower monthly payment can be the right choice if it keeps your budget safe, but it is worth seeing the total cost before deciding.

Rate, APR and fees

The headline interest rate is not always the full cost. The annual percentage rate, or APR, usually includes some fees as well, which makes it a fairer way to compare offers. Insurance, taxes, and arrangement fees may also be added to a payment. Always ask the lender for the total amount payable.

Common mistakes

Comparing loans by monthly payment alone. Mixing up monthly and yearly rates. Ignoring fees. Choosing the longest term by default. And borrowing up to the maximum offered rather than the amount your budget can comfortably carry.

Before you apply, try a few rates and terms in the Loan Payment Estimator, then add the payment to the Budget Calculator to see whether it still leaves room for savings.

Paying a loan off early

Many loans let you make extra payments. Because interest is charged on the remaining balance, any extra amount reduces every future interest charge. Even small overpayments early in the term can shorten the loan by months or years. Check first whether your lender charges an early repayment fee, and make sure you still have savings for emergencies before putting spare money towards a loan.