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  • Writer's pictureJohn W. Menn

How Does Interest Work, and What's a Loan Amortization?

When I first got started working in bankruptcy law and meeting with new clients, it surprised me how often people had no clue how loan interest worked, how it was calculated, and the impact it has on borrowing money. Over the years, I've had countless conversations explaining the concept, and explaining why, for example, the balance owed on a mortgage loan is now more than the original amount borrowed, after there's been a lengthy default, or why the amount showing up on garnishment paperwork is 2 or 3 times more than the original judgment amount entered with the court many years ago.


Most schools just don't teach these concepts, which is terrible, because it impacts virtually everyone, and so many people fall for predatory lending terms that hold them back financially, and so often they don't even understand what's happening to them.


So, for the first blog post on this site, I'll explain how it works.


What is Interest? Interest is the cost that your creditor charges to you for loaning you money. It is based on a percentage of the amount borrowed, and it is typically stated as the Annual Percentage Rate, or APR. So, for example, if you borrow $1,000.00 at 12% APR, compounded annually, and you make no payments in the first year, then after 1 year you will still owe the original $1,000.00 you borrowed, plus 12%, or an extra $120, at the end of that year, for a total amount owed of $1,120.00.


What is Compounding? Compounding refers to how often the interest accrues, which just means how often it's calculated and added to the total debt. Once interest is accrued, you will be paying interest on the total balance, including the interest (i.e., you're paying interest on interest!). So, in the example above, after 1 year, the debt would be $1,120.00, but then in the 2nd year, the interest is calculated based on that $1,120.00, so in year 2, additional interest of $134.40 will accrue (i.e., $1,120 x .12 = $134.40), so at the end of 2 years, the total debt will be $1,254.40.


It is possible to have an agreement that calls for simple interest only, where you are NOT paying interest on interest, but that is less common. All credit cards, home loans, and car loans that I have ever seen all call for compound interest.


A loan agreement will typically say how interest is calculated, and it is typical for interest to accrue monthly or even daily. So, in the case of a 12% APR loan, 1% of the outstanding balance would be added each month, which results in slightly more than a 12% increase in the total debt over the span of 12 months, because there will be interest accruals added to the loan that are generating more interest over the span of the year. See the download showing the comparison, here:

Annual vs Monthly Interest Accrual Example
.pdf
Download PDF • 241KB

So, in the example, the monthly interest accruals result in $126.83 of interest racking up in the 1st year, which means the effective rate is slightly more than 12% based on how its accrued. Daily accruals result in a marginally higher end balance still.


What is an Amortization? An Amortization is a series of equal loan payments that, by the time they have all been paid, will have paid off the full principal balance plus the interest that accrued over the life of the loan. Often, people will only be interested in the amount of the monthly payment, but that is only one part of the total picture. The following download is a loan amortization calculator:


Loan Amortization Calculator
.xlsx
Download XLSX • 39KB

This calculator illustrates several things, which will depend on the amount borrowed, the interest rate, and the length of the repayment (these cells are highlighted in yellow on the spreadsheet so they are easy to see - change those numbers and the rest of the calculator will update automatically):

  • The monthly payment. A longer repayment term, or a lower interest rate, will result in a lower payment, whereas a shorter payment term or higher interest rate will result in a higher payment. With a normal amortization, all payments will be equal, and the loan will be fully paid at the end. However, many lenders include a "balloon payment" requirement (this is very common in business related loans, but is found in some consumer loans too). If a balloon payment is due at some point during the loan, then the remaining outstanding principal and interest balance will be due on the balloon date. In that case, you will need to have a refinance lined up, or have a deal worked out with your lender to renew the loan.

  • The total amount paid and total interest paid. You will see that if the repayment term is longer, the total amount paid will be greater, because you are taking longer to pay the debt back, and more interest accrues. So, in our $1,000.00 at 12% example, a 1 year repayment results in monthly payments of $88.85, and total interest accrued of $66.19. But, if the term is lengthened to 5 years (replace the highlighted "1" in "length (years)" with a "5", the payments are now $22.24 per month (more affordable on a monthly basis), but the total amount paid is $1,334.67 and total interest paid is now $334.67 (much more interest accrues over that 5 year span, because the debt is being paid down much more slowly)

  • Running Principal Balance / Cumulative Principal Paid. Looking at a loan amortization is very helpful in understanding where your money is going, and help you plan for the future. It will show what the principal balance will be at any given point in the future (in case you want to, or have to, pay the debt off), and how much principal you would have paid down on the loan balance (this may be roughly equivalent to, or at least helpful in determining, equity you are building in an asset like a home that you're buying over time).

Thanks for reading, and please let me know if you have any issues using the downloads here. I hope you find them helpful!

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