How one payment splits
Interest is charged on the balance you still owe. In any month, the interest due is the balance times the monthly rate (the annual rate divided by 12). The scheduled payment is fixed, so whatever is left after the interest goes to principal and lowers the balance. Next month the interest is computed on the lower balance, so a little more of the same payment goes to principal. The process repeats until the balance reaches zero on the last payment, which is what "amortized" means.
For a $20,000 loan at 7% over 5 years: r = 7% ÷ 12 = 0.5833% a month, n = 60, and the payment comes to $396.02. The loan calculator runs this formula for any amount, rate and term, and the car loan calculator adds a down payment, a trade-in and sales tax to the amount borrowed.
A car loan, month by month
The first six payments of the $20,000 loan. The payment never changes; the two parts inside it do.
| Month | Payment | Interest | Principal | Balance after |
|---|---|---|---|---|
| 1 | $396.02 | $116.67 | $279.36 | $19,720.64 |
| 2 | $396.02 | $115.04 | $280.99 | $19,439.66 |
| 3 | $396.02 | $113.40 | $282.63 | $19,157.03 |
| 4 | $396.02 | $111.75 | $284.27 | $18,872.76 |
| 5 | $396.02 | $110.09 | $285.93 | $18,586.82 |
| 6 | $396.02 | $108.42 | $287.60 | $18,299.22 |
Year by year the balance falls faster and faster, because less of each year's payments is eaten by interest:
| Year | Interest paid | Principal paid | Balance at year end |
|---|---|---|---|
| 1 | $1,290.33 | $3,461.96 | $16,538.04 |
| 2 | $1,040.06 | $3,712.22 | $12,825.82 |
| 3 | $771.71 | $3,980.58 | $8,845.23 |
| 4 | $483.95 | $4,268.34 | $4,576.90 |
| 5 | $175.39 | $4,576.90 | $0.00 |
Total interest over the five years: $3,761.44, which is 18.8% of the amount borrowed. The first year alone accounts for $1,290.33 of it.
A 30-year mortgage: the slow start
The longer the term, the more extreme the early split. On a $300,000 mortgage at 6.5% the payment is $1,896.20 for principal and interest. Seven points along the schedule:
| Payment | Interest | Principal | Balance after | Principal share |
|---|---|---|---|---|
| 1 | $1,625.00 | $271.20 | $299,728.80 | 14.3% |
| 60 | $1,523.20 | $373.01 | $280,832.93 | 19.7% |
| 120 | $1,380.41 | $515.80 | $254,328.38 | 27.2% |
| 180 | $1,182.95 | $713.25 | $217,677.42 | 37.6% |
| 240 | $909.90 | $986.30 | $166,995.85 | 52.0% |
| 300 | $532.33 | $1,363.87 | $96,912.49 | 71.9% |
| 360 | $10.22 | $1,885.99 | $0.00 | 99.5% |
The principal share does not pass 50 percent until payment 233, in year 20. After ten years of payments the balance is still $254,328, and the total interest over the full term comes to $382,633, more than the amount borrowed. This is also why a refinance or a sale in the first years returns so little equity from the payments alone: most of what was paid was interest. The mortgage calculator shows the full schedule and the balance at any month, and the refinance calculator compares the rest of an old schedule with a new one.
What an extra payment does
Any amount paid above the schedule comes straight off the balance, and every later month's interest is computed on that smaller balance. On the $20,000 car loan, $100 extra every month cuts the total interest from $3,761.44 to $2,867.72 and ends the loan after 47 payments instead of 60. The saving is largest when the extra payments come early, when the balance and the interest are highest. Two cautions: make sure the lender applies the extra amount to principal rather than treating it as an early next payment, and compare the loan's rate with what the money could earn elsewhere before prepaying a cheap loan.
Reading an amortization schedule
- Payment number and date: one row per scheduled payment.
- Interest: last month's balance times the monthly rate. Falls every month on a fixed-rate loan.
- Principal: the payment minus the interest. Rises every month by the same amount the interest fell.
- Balance: what you would owe if you paid the loan off after this payment, before any fees. The number a lender quotes as a payoff amount is this balance plus the interest accrued since the last payment.
- Totals: the interest column summed is the true cost of borrowing; principal summed equals the amount borrowed.
Variable-rate loans and loans with fees follow the same mechanics but with a rate that resets or a cost that is not in the schedule; the APR folds the fees into one comparable rate, and the ARM guide shows how a payment is recomputed when the rate changes.
Frequently asked questions
What does amortization mean?
Paying off a loan with a fixed schedule of equal payments, each of which covers that month's interest first and puts the rest toward the balance. Because the balance falls, the interest part of each payment falls too and the principal part grows, so the loan is paid off exactly on the last scheduled payment.
Why is so much of my early payment interest?
Because interest is charged on the balance you still owe, and at the start that is the whole loan. On a $300,000 mortgage at 6.5% the first payment of $1,896.20 carries $1,625.00 of interest and only $271.20 of principal. The principal share passes the interest share in month 233, and the last payment is almost all principal.
How is the monthly payment calculated?
Payment = P × r ÷ (1 − (1 + r)^−n), where P is the amount borrowed, r the monthly interest rate (the annual rate divided by 12) and n the number of payments. It is the one payment amount that, repeated n times, pays the interest each month and brings the balance to exactly zero at the end.
Do extra payments go to principal?
On a standard amortizing loan, any amount above the scheduled payment reduces the balance, and every later month's interest is computed on that smaller balance. $100 extra a month on the $20,000 car loan in the example saves $893.72 of interest and ends the loan 13 months early. Check that the lender applies extra amounts to principal rather than to the next payment.
What is the difference between amortizing and interest-only loans?
An interest-only loan charges only the interest each month and leaves the balance unchanged until a lump sum is due. An amortizing loan builds the repayment into the monthly amount. Interest-only payments are lower for the same balance, but the balance never falls, so the total interest over the same period is higher.
General information, not tax, legal or financial advice.