The basic mechanics
Each period, interest is calculated on the outstanding balance. Your payment covers that interest first; whatever is left reduces the balance. As the balance falls, less of each payment goes to interest and more goes to the principal. This process is called amortisation.
A worked example
On a 200,000 loan at 12 percent a year over five years, the monthly payment is roughly 4,450. In the first month, interest alone is about 2,000 — so under 2,450 reduces the debt. By the final year the split has reversed almost entirely.
Why the term matters more than people expect
- A longer term lowers the monthly payment and raises total interest.
- A shorter term raises the payment and can save a very large amount overall.
- Extending a loan to reduce a payment is sometimes necessary, but it is never cheap.
Rate is not the same as cost
Two loans at the same advertised rate can cost very different amounts once initiation fees, monthly service fees and credit insurance are included. Always compare the total repayable figure, not the headline rate.
Why extra payments are so effective
Any amount above the required payment goes straight to the principal, which reduces every future interest charge. Even a small consistent addition can remove months from a loan.
Fixed versus variable rates
A fixed rate keeps the payment predictable. A variable rate moves with the market, so a rise increases your payment. If your budget has no slack, predictability has real value.