The other day we talked about different kinds of loans. I thought I would keep up this loan trend and debunk a myth I hear quite often. I hear people say that the interest on a loan is loaded on the front. Basically that you pay all the interest of a loan first, and then start paying off the principal. I was actually told this when I was a teenager. A teacher said that you pay the interest on a loan first. I’ve also heard people say that they didn’t want to refinance something because they’ve “already paid all the interest” on it. I’ve had intelligent people argue with me about this fact. That they shouldn’t refinance because they don’t want to “pay all that interest again”.
They are (wrongly) saying that loans work like this…
You borrow $30,000 at 5% for 5 years. Your payment would be $566.14 and you would pay a total of $3,968.22 in interest. They are saying that the first 7 payments that you make would be 100% interest and only after you have paid the whole $3,968.22 of interest would you start to make a dent in the $30,000 that you borrowed.
It doesn’t work like that. If it did then yes, it wouldn’t be smart to refinance because you could pay almost $4,000 in interest and then turn around and pay it again to someone else. But it can’t work that way because interest is a fee you pay to have use of someone’s money. The interest of $3,968.22 is the fee to borrow the money for the whole 5 years. If you pay the loan off early then you didn’t have use of their money for the full term, so they can’t charge you the full fee.
Let’s say that you refinanced that loan after 7 months. At the 7 month mark you would have paid them all their interest and then paid them back the $30,000. You paid to borrow the money for 5 years but only borrowed it for 7 months. They can’t charge you for that extra time. They would have to pay you back the interest that you didn’t owe.
How it actually works
Each month a little bit of interest accrues on your loan. How much depends on the interest rate and balance of the principal. Using the same loan as above you would accrue $125.00 in interest in the first month. ($125 is the fee for borrowing $30,000 for 30 days) You would make your first payment of $566.14 and pay $125 in interest. That would leave $441.14 to go towards the principal of the loan bringing it to $29,558.86.
The next month $123.16 in interest would accrue. Smaller principal balance means less interest. You would make your second payment of $566.14 and this time $442.98 would go to the balance of the loan. This would bring the balance down to $29,115.89.
In the third month there would be a little less interest accrued because the balance is a bit smaller. Less interest accrued means more of your payment can go to the balance of the loan. And so on until the loan is paid off.
The bank can never charge you interest for a time period when you didn’t borrow money. Interest accrues on a daily basis. If you were to pay the loan off after just two weeks then you would pay 14 days worth of interest. Interest is only applied to your statement once per month, but that doesn’t mean it’s not accruing.
You can use a loan calculator to run the numbers yourself if you want to look at them month by month. Make sure to click “Show Amortization Table” to see the monthly details.
Why it feels like you pay all the interest up front
You do pay the bulk of the total interest in the early part of the loan because that is when the balance is the largest. As the balance goes down you are charged less and less interest per month. This allows more of your payment to pay down the loan, which then allows you to pay less interest. It’s a snowball. However, you are always only paying interest on the current balance of the loan. The interest is not loaded at the front.
How to pay less interest
There are two ways to pay less interest. The first is to have a lower interest rate. If less interest is accruing then more of your payment can go to the balance of your loan. The second way is to send extra with your loan payment. If you make a larger payment more money can go to the principal balance which will help get it down as quickly as possible.