How loan interest actually works

Most people know a loan costs interest. Far fewer know that the order in which interest is charged means a payment made in year one is worth several times a payment made in year twenty.

This is general information, not financial advice. Figures are illustrative and rounded. Anything involving your own money should go past someone qualified and regulated to advise on it.

Why your early payments are mostly interest

A repayment loan uses amortisation. Your monthly payment stays the same, but its composition changes completely over the life of the loan.

Each month, interest is charged on the balance that is currently outstanding. Whatever is left of your payment after covering that interest reduces the balance.

Take a £200,000 mortgage over 25 years at 5%. The monthly payment is roughly £1,169.

In month one, interest on £200,000 at 5% annually is about £833. So of your £1,169, some £833 is interest and only £336 touches the debt. You have paid over a thousand pounds and the balance moved by a third of it.

By year fifteen the balance is far lower, so the interest portion is smaller and most of the payment reduces the debt. In the final year almost the entire payment is principal.

This is not a trick and nothing is hidden. It follows inevitably from charging interest on the outstanding balance. But it explains two things people find surprising: why a mortgage balance barely moves in the early years, and why the total repaid is so much larger than the amount borrowed. On that example, roughly £351,000 is repaid on a £200,000 loan.

The loan calculator shows the split month by month, which is worth looking at once for any loan you are considering.

APR versus interest rate

These are different numbers and the gap between them is where costs hide.

The interest rate is what is charged on the balance. The APR — annual percentage rate — is designed to fold in the compulsory fees as well: arrangement fees, booking fees, some insurance. It exists so that two offers can be compared on one number.

A 4.5% rate with a £2,000 arrangement fee may cost more than a 4.8% rate with no fee, depending on the size and length of the loan. The APR is meant to capture that.

Three cautions. First, APR assumes you keep the loan for its full term, so on a mortgage with a two-year fixed rate it is close to fictional. Second, "representative APR" in advertising only has to be offered to 51% of accepted applicants — the other 49% may be offered worse. Third, not every cost is required to be included, and what counts varies by jurisdiction.

For credit cards, note that APR usually excludes late fees and foreign transaction charges, and that a purchase rate and a cash-advance rate are typically very different.

What the term really costs

Lengthening a loan lowers the monthly payment and raises the total substantially. Using the same £200,000 at 5%:

Going from 25 to 35 years saves about £159 a month and costs about £73,000. That may still be the right decision — affordability now is a real constraint and a payment you cannot make is worse than one that costs more overall — but it should be a decision made with the number in view.

Small rate differences compound similarly. On that 25-year loan, 5% versus 5.5% is roughly £60 a month and about £18,000 over the term.

Why overpaying works so well

Here is the part worth acting on. An overpayment goes entirely against the principal — none of it is interest. And because it removes that balance for the whole remaining term, you avoid every future month of interest on it.

On the £200,000 example, an extra £100 a month from the start cuts roughly three years off the term and saves in the region of £25,000. An extra £200 saves closer to £45,000.

Timing matters enormously. Overpaying in year one avoids 24 years of compounding on that amount; the same overpayment in year twenty avoids five. Early payments are worth several times late ones.

Before overpaying, check three things: whether early repayment charges apply, whether the lender reduces the term or the payment — reducing the term is what saves the interest, and many lenders default to the other — and whether you have higher-rate debt elsewhere, since paying off a 22% credit card beats overpaying a 5% mortgage every time.

And keep an emergency fund. Money paid into a mortgage is very hard to get back out.

Compounding, in both directions

Compound interest is interest charged on interest. It is what makes long debt expensive and long saving effective, and it is the same mechanism pointed in opposite directions.

A rough tool: the rule of 72. Divide 72 by the annual rate to get the years for a balance to double. At 6%, twelve years. At 18% — a fairly ordinary credit-card rate — four years.

That last number explains why minimum payments on a credit card are so punishing. Pay only the minimum on a £3,000 balance at 20% and you can be repaying for well over a decade, and pay more in interest than the original debt.

Frequency matters too. Interest compounded daily costs slightly more than the same nominal rate compounded annually, which is why the effective rate can exceed the advertised one. The percentage calculator handles the underlying arithmetic, and our guide to calculating percentages covers the reverse-percentage trap that catches people working backwards from a total.

Things worth checking before you sign

• Early repayment charges — typically a percentage of the balance, often during a fixed-rate period.
• Whether the rate is fixed or variable, and what happens when a fixed period ends. Reverting to a standard variable rate is a common and expensive surprise.
• Fees added to the loan rather than paid upfront — you then pay interest on the fee for the whole term.
• The total amount repayable, which lenders are generally required to state. It is the number that makes the cost real.
• Whether overpayments reduce term or payment, as above.
• Payment protection or add-on insurance — check whether it is optional, and it usually is.

Run your own numbers before you rely on anyone's illustration. The loan calculator gives the monthly payment, the total interest and the full amortisation schedule, and Pikkit has the rest of the financial tools — including the VAT calculator and the discount calculator.