How Loan Interest Works: Amortization Explained
Published · QuickTools team
You borrow $25,000, the payment is $501 a month, and after a year you have paid $6,012 — yet you still owe about $20,700. Where did the other $1,700 go? It went to interest, and understanding exactly how is the key to paying a lot less of it.
The basic idea
Interest is charged on the balance you still owe, every month. With a fixed-rate loan, your monthly payment is set so that the loan is exactly paid off at the end of the term. Each payment is split in two:
- Interest for that month = remaining balance × (annual rate ÷ 12)
- Principal = the rest of the payment, which reduces the balance
Because the balance is highest at the start, the interest portion is highest at the start too. As the balance falls, interest shrinks and more of each payment goes to principal. This schedule is called amortization.
A worked example
$25,000 at 7.5% for 5 years. Monthly rate = 7.5% ÷ 12 = 0.625%. Payment ≈ $500.95.
| Month | Payment | Interest | Principal | Balance |
|---|---|---|---|---|
| 1 | $500.95 | $156.25 | $344.70 | $24,655.30 |
| 2 | $500.95 | $154.10 | $346.85 | $24,308.45 |
| 12 | $500.95 | $131.80 | $369.15 | $20,718.42 |
| 60 | $500.95 | $3.11 | $497.84 | $0.00 |
Total paid: $30,057. Total interest: $5,057. You can see the full 60-month schedule — and try your own numbers — in the Loan Calculator.
The formula
The payment comes from the standard amortization formula:
M = P × r(1 + r)ⁿ ÷ ((1 + r)ⁿ − 1)
where P is the amount borrowed, r the monthly rate as a decimal and n the number of monthly payments. You never need to calculate it by hand, but it explains why rate and term matter so much: both appear as exponents.
What changes the total cost
1. The term
Same $25,000 at 7.5%:
| Term | Monthly payment | Total interest |
|---|---|---|
| 3 years | $777.66 | $2,996 |
| 5 years | $500.95 | $5,057 |
| 7 years | $383.46 | $7,210 |
The 7-year loan feels cheaper each month but costs $4,200 more than the 3-year loan. Lenders and car dealers often advertise the monthly payment for exactly this reason.
2. The rate
On a 30-year $300,000 mortgage, the difference between 6% and 7% is about $197 a month — and roughly $71,000 over the life of the loan. A better credit score, a larger down payment or simply comparing three lenders can be worth more than any other financial decision you make that year.
3. Extra payments
Every extra dollar goes straight to principal, which reduces the interest charged in every following month. On the $25,000 loan above, paying an extra $50 a month shortens it by 6 months and saves around $560 in interest. Try it in the calculator’s “extra monthly payment” field.
APR vs interest rate
The interest rate is the price of borrowing the principal. The APR (annual percentage rate) adds certain fees, such as origination or broker fees, and expresses everything as a yearly rate. When comparing loans, compare APRs: a loan with a lower rate but high fees can cost more overall.
Interest working for you
Compound interest is the same maths running in the opposite direction. The $5,057 of interest on that car loan, if invested instead at 7% for 20 years, would grow to around $19,500. See how in the Compound Interest Calculator.
Key takeaways
- Early payments are mostly interest; that’s normal, not a trick.
- Compare loans by total interest and APR, not just the monthly payment.
- Shorter terms and extra payments save far more than they seem to.
- Small rate differences become large amounts on big, long loans.
This article is for general information and is not financial advice.