A loan payment looks like a single number, but it hides a simple idea: every month you pay the interest that has built up, and whatever is left over reduces what you owe. Once you see how that works, it is easy to understand why a longer loan costs more, why extra payments help, and why two loans with the same monthly payment can cost very different amounts. This guide uses one worked example, a $20,000 car loan at 6% for 4 years, and every number in it is calculated by code.
The loan payment formula
Most car loans, personal loans and mortgages are “fully amortizing” loans with a fixed rate. The payment is the same every month and is worked out with the annuity formula:
P = amount borrowed, r = monthly rate (annual rate ÷ 12), n = number of monthly payments
For $20,000 at 6% a year over 48 months, r = 0.0050 and the payment is $469.70. Over the whole loan you pay $22,545.63, which means the borrowing costs $2,545.63 in interest. You can check this with our loan calculator.
How each payment is split between interest and principal
Each month the lender charges interest on the balance you still owe: balance × r. The rest of your payment reduces the balance (the principal). Because the balance is highest at the start, early payments are mostly interest, and later payments are mostly principal.
| Payment | Amount | Interest | Principal | Balance after |
|---|---|---|---|---|
| 1 | $469.70 | $100.00 | $369.70 | $19,630.30 |
| 2 | $469.70 | $98.15 | $371.55 | $19,258.75 |
| 24 | $469.70 | $55.06 | $414.64 | $10,597.79 |
| 48 | $469.70 | $2.34 | $467.36 | $0.00 |
Payment 1 is mostly interest and payment 48 is almost all principal, but the total payment never changes.
This is why paying off a loan early saves more than you might expect: the payments you skip are the ones that would have been mostly principal, and the interest that would have built up on the remaining balance never gets charged.
A longer term lowers the payment and raises the cost
Stretching a loan over more months makes each payment smaller, which is why lenders like to advertise the monthly figure. But you owe money for longer, so interest has more time to build up.
| Term | Monthly payment | Total interest | Total repaid |
|---|---|---|---|
| 3 years | $608.44 | $1,903.79 | $21,903.79 |
| 4 years | $469.70 | $2,545.63 | $22,545.63 |
| 5 years | $386.66 | $3,199.36 | $23,199.36 |
| 6 years | $331.46 | $3,864.96 | $23,864.96 |
The same $20,000 at 6%. Going from 3 to 6 years cuts the payment but more than doubles the interest.
When you compare offers, look at the total cost as well as the monthly payment, and pick the shortest term you can afford comfortably.
What extra payments do
Any extra money you pay goes straight to principal, as long as your lender applies it that way. That lowers the balance, so less interest is charged next month, and the effect builds over time. On the 48-month loan above, paying an extra $50 each month clears the loan in 3 years 7 months instead of 4 years and saves $276.80 in interest. Try your own figures in the “extra payment” box of the loan calculator.
Before you pay extra, check three things with your lender: whether there is a prepayment penalty (some loans charge a fee for paying early), whether extra payments are applied to principal, and whether they need to be marked as “principal only”.
Interest rate or APR?
The interest rate is the price of borrowing the money and is what your payment is calculated from. The annual percentage rate (APR) also includes certain fees, so it shows the overall yearly cost of a loan. Use the interest rate to work out the payment and the APR to compare offers from different lenders, because a low rate with high fees can cost more than a slightly higher rate with none.
Mortgages and credit cards work differently
A mortgage payment uses the same formula, but your monthly housing cost also includes property tax, insurance and sometimes mortgage insurance, so use the mortgage calculator for the full figure. A credit card has no fixed term at all: the payment you choose decides how long it takes to clear, and paying only the minimum can take many years. The credit card payoff calculator shows how a higher payment shortens the time and the interest.
A short checklist before you borrow
- Compare total cost, not just the monthly payment.
- Ask for the interest rate, the APR, all fees and the total amount you will repay.
- Choose the shortest term whose payment fits your budget with some room to spare.
- Ask about prepayment penalties and how extra payments are applied.
- Check whether the rate is fixed or variable. A variable rate can change your payment.
This guide explains how loans work in general. It is not financial advice, and your lender’s official figures are the ones that apply to your loan.
Sources and further reading
- Annuity: the math behind loan payments (Wikipedia)
- CFPB: Owning a Home tools and guides
- Annual percentage rate (Wikipedia)
Numbers in worked examples are calculated by code and checked by automated tests. How we test.