How Loans Work
Taking out a loan means borrowing a lump sum of money (the principal) from a lender and agreeing to pay it back over a specific period of time (the term), usually with interest. The interest is essentially the "fee" you pay for the privilege of using someone else's money.
The Amortization Formula
Most personal loans, auto loans, and mortgages are "fully amortizing." This means your monthly payment is calculated so that at the end of the term, the balance reaches exactly zero. The math behind it looks like this:
M = P [ i(1 + i)n ] / [ (1 + i)n – 1 ]
- M: Total monthly payment
- P: The principal loan amount
- i: Your monthly interest rate (Annual rate / 12)
- n: Total number of months (Years × 12)
Principal vs. Interest
In the early years of a loan, a large portion of your monthly payment goes toward paying off interest, while only a small amount chips away at the actual loan balance. As time goes on, this flips—you pay less interest and more principal.
Pro Tip: By making even one extra payment per year applied directly to the principal, you can often shorten your loan term by months or even years and save significantly on interest.
Frequently Asked Questions
Does a longer loan term save me money? ▼
No, usually the opposite. A longer term (e.g., 7 years vs 3 years) lowers your monthly payment, which helps cash flow, but it drastically increases the total interest you pay over the life of the loan.
What is a prepayment penalty? ▼
Some lenders charge a fee if you pay off your loan early, because they lose out on the interest they expected to earn. Always check if your loan agreement has a "prepayment penalty" clause before making extra payments.