Loan payments: why the early years are almost all interest

Annuity: constant payment, changing contents

Most consumer and home loans are annuity loans: the monthly payment is the same throughout. What changes is its composition. Interest is charged each month on the remaining balance, so early on, when the balance is large, the interest share is large and the principal share small.

Example: a 10,000 EUR loan at 9% over five years. The payment is 207.58 EUR. In the first month 75 EUR of that is interest and only 132.58 EUR reduces the debt. In the final month interest is about 1.55 EUR and the rest clears the balance.

The first month's interest is simple arithmetic: 9% a year divided by 12 is 0.75% a month, and 0.75% of 10,000 EUR is 75 EUR. In month two the balance is already 9,867.42 EUR, so interest is 74.01 EUR and principal 133.58 EUR. Each month the split shifts a few cents towards principal, and that shift speeds up towards the end of the loan.

The same loan, year by year

A monthly schedule is long, but yearly totals show the pattern most clearly. Each year you pay about 2,491 EUR in total, yet the split between interest and principal keeps moving.

• Year 1: principal 1,658.30 EUR, interest 832.69 EUR, balance at year end 8,341.70 EUR.
• Year 2: principal 1,813.85 EUR, interest 677.14 EUR, balance at year end 6,527.84 EUR.
• Year 3: principal 1,984.00 EUR, interest 506.99 EUR, balance at year end 4,543.83 EUR.
• Year 4: principal 2,170.13 EUR, interest 320.88 EUR, balance at year end 2,373.70 EUR.
• Year 5: principal 2,373.69 EUR, interest 117.30 EUR, loan fully repaid.

What the schedule tells you

First-year interest of 832.69 EUR is almost a third of the loan's total interest of 2,455.01 EUR. After 12 payments you have paid nearly 2,500 EUR, yet the debt has fallen by only 1,658.30 EUR. If you sell something bought on credit within the first year, the outstanding balance is often higher than intuition suggests.

Halfway through the term, after 30 payments, half the loan is not yet repaid. At the end of year 3 the balance is 4,543.83 EUR, so 36 months have cleared about 55% of the principal while 60% of the time has passed. That is simply how an annuity works, not a trick by the bank.

Annuity or equal principal

The other common schedule is an equal-principal loan. The same slice of debt is repaid every month, and interest is still charged on the balance. The payment therefore starts higher and falls each month.

The same 10,000 EUR at 9% over five years with equal principal repays 166.67 EUR of debt every month. The first payment is 166.67 + 75.00 = 241.67 EUR, month 13 is 226.67 EUR, month 25 is 211.67 EUR, month 37 is 196.67 EUR and the last payment is 167.92 EUR. From month 29 onward the payment is lower than the annuity's 207.58 EUR.

• Annuity: payment 207.58 EUR throughout, total interest 2,455.01 EUR.
• Equal principal: first payment 241.67 EUR, last 167.92 EUR, total interest 2,287.50 EUR.
• The equal-principal schedule saves 167.51 EUR of interest here.
• The price is a payment 34.09 EUR higher in month one, exactly when the budget is usually tightest.

How much the interest rate changes things

With the same 10,000 EUR over five years, a higher rate changes the monthly payment relatively little but the total cost much more. The payment gap between 5% and 15% is under 50 EUR, while total interest more than triples.

• At 5%: payment 188.71 EUR, total interest 1,322.74 EUR.
• At 7%: payment 198.01 EUR, total interest 1,880.72 EUR.
• At 9%: payment 207.58 EUR, total interest 2,455.01 EUR.
• At 12%: payment 222.44 EUR, total interest 3,346.67 EUR.
• At 15%: payment 237.90 EUR, total interest 4,273.96 EUR.

The term costs more than the rate

A longer term lowers the payment and raises the total cost, often far more sharply than people expect.

The pattern holds for small loans too. 10,000 EUR at 9%: over 2 years the payment is 456.85 EUR and total interest 964.34 EUR; over 3 years 318.00 EUR and 1,447.90 EUR; over 7 years 160.89 EUR and 3,514.83 EUR; over 10 years 126.68 EUR and 5,201.09 EUR. The ten-year loan costs more than five times the interest of the two-year one.

• A 150,000 EUR home loan at 4.5% over 30 years: payment 760 EUR, total interest 123,610 EUR.
• The same loan over 20 years: payment 949 EUR, total interest 77,754 EUR.
• Paying 189 EUR more a month saves over 45,000 EUR in interest.
• A 10,000 EUR loan at 9% over 5 years: 12,455 EUR repaid, of which 2,455 EUR is interest.
• The middle option, 25 years: payment 833.75 EUR, total interest 100,124.62 EUR.

The interest rate is not the whole price

Contract fees, monthly charges, insurance requirements and valuation costs do not appear in the interest rate. That is why offers should be compared on the annual percentage rate of charge, which folds those in, rather than on the headline rate alone.

The APR expresses all mandatory costs of the loan as a single yearly percentage. Whenever a loan carries fees, the APR is higher than the nominal rate. The gap is largest on small, short loans, because a one-off contract fee is spread over a small amount and a short time. Of two offers with the same rate, the one with the lower monthly payment can still be the more expensive.

A floating-rate loan adds one more variable: the base rate moves and the payment moves with it. For a home loan it is always worth working out what happens to the budget if the rate rises by a couple of percentage points.

A stress test in numbers: a 150,000 EUR loan over 30 years at 4.5% has a payment of 760.03 EUR. If the total rate were 6.5% for the whole term, the payment would be 948.10 EUR, 188.07 EUR more, and total interest would reach 191,316.73 EUR. A curious detail: the 30-year payment at 6.5% is almost the same as a 20-year loan at 4.5%.

Early repayment works in reverse

Because interest is charged on the balance, every extra principal payment is worth more the earlier it is made. The same amount paid in year one saves several times more interest than in the final year.

Before making a partial repayment, check the contract for whether the bank reduces the payment or shortens the term. Shortening the term usually saves more; reducing the payment gives more flexibility.

Here is an extra 1,000 EUR payment on the same 10,000 EUR loan. The timing and the option chosen change the saving several times over. The calculation assumes the contract charges no fee for early repayment.

• 1,000 EUR after payment 12, term shortened: total interest 2,054.31 EUR, saving 400.70 EUR, loan ends in month 54.
• 1,000 EUR after payment 12, payment reduced: new payment 182.70 EUR, total interest 2,260.52 EUR, saving 194.49 EUR.
• 1,000 EUR after payment 48, term shortened: total interest 2,378.37 EUR, saving 76.64 EUR, loan ends in month 55.

Common mistakes when comparing loan offers

Most bad borrowing decisions come not from wrong maths but from the wrong comparison. These are the situations where choosing by monthly payment leads to the more expensive loan.

• Comparing offers with different terms by their payment, when the longer term hides a larger total cost.
• Looking only at the nominal rate when one offer has a contract fee or monthly charge and the other does not.
• Budgeting a floating-rate home loan at today's rate only.
• Assuming half the debt is gone halfway through the term, which is not true for an annuity.
• Making an extra payment without checking whether the bank shortens the term or lowers the payment.

Checklist before signing

Before you sign, find an answer to every question below. Most of them are in the offer or the standard terms of the contract.

• What is the APR, and how far is it from the nominal rate?
• How much will you repay in total over the whole term, not just per month?
• Is the schedule an annuity or equal principal, and can you choose?
• Is the rate fixed or floating, and what happens to the payment if it rises by 2 percentage points?
• Is early repayment allowed, and is there a fee for it?
• After a partial repayment, does the term shorten or does the payment fall?
• Does the payment still fit the budget if your income drops for a while?

Look at your own schedule

The loan calculator shows the payment, the total cost and a month-by-month amortisation schedule, so the split between interest and principal is visible in black and white. The home loan calculator additionally handles the quirks of longer terms.

The compound interest calculator shows the same logic from the other side: when you save instead of borrowing, interest works for you and time is on your side.