How Does Interest On Debt Work?

We are going to take a quick break from the Marriage and Money series to address a reader’s question about interest on debt!

How does interest on debt work? I think this is a subject that many people have questions about or do not fully understand.

What is interest?

From a borrower’s perspective, interest is the payment or cost of borrowing money. From a lender’s perspective, the interest paid by the borrower is their income for allowing others to temporarily use their funds. It can be thought of as a borrower paying “rent” for use of the money and the lender receiving “rent” as compensation for lending their money.

Interest is most clearly illustrated by considering an interest-only loan, where the payment just goes toward interest. For example, Jack lends Reid $1,000 for three years at 10% interest per year. The total interest paid for each year will be $100 (1,000 * 10%). At the end of the three-year period, Reid will have to repay the $1,000 amount borrowed.

Considering an interest-only loan shows clearly how interest is calculated. However, most common types of loans are not interest-only. The monthly payment is divided between paying interest and paying back the borrowed amount. Paying back a loan over time according to a set schedule is called amortization.

What is amortization?

As mentioned above, amortization is the process through which a loan is paid back over time according to a set schedule. For example, a traditional, 30-year mortgage is fully amortized over the 30-year period – a portion of the monthly payment goes toward paying off the loan’s balance until the loan is completely paid off.

Interestingly, the amortization schedule can be different than the period that the interest rate is fixed. For example, you can have a loan that amortizes over a 25 year period (will be paid off in 25 years), but the rate may only be fixed for five years. At the end of the five-year period, the rate may be changed and the monthly payment recalculated.

How is interest calculated?

The interest due on a loan is based on the loan’s remaining balance. As mentioned above, this is easiest to understand for an interest-only loan, because the balance does not change during the life of the loan.

For an amortizing loan, it gets a little more complicated, because the balance of the loan is being reduced. However, the interest portion of the payment is still always based on the remaining balance. It is calculated each month, because the balance is always changing.

Here is an example of a 24-month, fully amortizing car loan. The initial loan amount is $10,000 and the interest rate is 12% per year:

The total payment is $471 per month (yellow column). The monthly payment is broken into the interest (green column) and principal or paying back the loan (blue column). Notice that the interest portion drops throughout the repayment period. The interest is calculated based on the beginning loan balance and is 1% per month (12% annual rate / 12). So in the first month, the interest payment is $100, which is calculated based on the $10,000 beginning loan balance (10,000 * 1%). The ending loan balance for each period is the beginning loan balance minus the principal part of the monthly payment – in the first month the ending loan balance is $9,629 (10,000 – 371).

Interest is calculated based on the remaining loan balance

There are different types of loans and related features and terminology that we may cover in a future post or series.

However, for the purpose of this post, just remember that interest is calculated based on the remaining loan balance!

If you have any comments, questions, or ideas for future posts, please let me know

I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.