Last weekend, when visiting family for Easter, I overheard my younger cousin Kyle talking about a problem with his student loans. He complained that he’d been paying $200 per month for about 5 years and has only paid off $2000 from the original loan amount. “That can’t be right!”, he insisted. Unfortunately, it was.
What Kyle didn’t realize, is that most of his monthly payments have been going towards interest. In order to keep his monthly payment lower, he chose a payback schedules based on a 30-year loan. As a result, only a small fraction of each payment has gone towards paying down the principal. This is typical with longer payment plans. And after going over some numbers with my cousin, he now understands that by paying only a little more each month, he can pay off his debt quicker and cheaper.
Understanding the difference between Interest and Principal
It’s an important lesson for Kyle and anyone who ever considers taking out a loan. To fully understand what’s going on when you pay back a loan, it’s best to first understand the difference between interest, and principal:
Interest – is a fee you pay to a financial institution for borrowing money. Based on (usually) annual percentage rates (APR) of the principal balance.
Principal balance – is the remaining amount owed on a loan, not including interest.
Interest payment – is the amount of interest to be paid with each payment.
Principal payment – is the amount of each payment that goes towards paying down the principal balance of a loan.
Put more simply, your principal balance is how much money is still owed from the original loan, and interest is calculated as a percentage of that balance. Most payments plans have a component of both interest and principal with each installment. The interest portion decreases over time as the principal balance is paid down.
Calculating your interest payments
Knowing how much of your payments are going towards interest is the best way to illustrate what is going on when paying down debt. All you need is your principal balance and current interest rate on the loan. Let’s calculate the monthly interest payments for a $20,000 loan at 5% APR:
[Principal Balance * (annual interest rate/100)] / 12 months = Monthly interest payments
[$20,000 * (.05)] / 12 = $83.33
Using the above example, the monthly interest payment would be $83.33. So if the borrower was paying the loan back at $100 per month, less than $17 (per payment) would go towards paying down the principal balance. At first…
Paying down the principal balance
With each payment, even if you’re paying mostly interest for the beginning portion of a loan schedule, the principal balance starts to shrink. Faster and faster, too, as the more it shrinks, the less is owed each month in interest. This also means the more you pay each month, the faster your principal shrinks, the less you will pay overall in interest, and the faster you pay off your loan. It’s essentially reverse compounding interest.
Let’s start by continuing the example above with $100/month payments:
Interest payment : $83.33/month
Principal payment: $16.67/mo. * 12 months = $200
After a year, about $19,800 of the principal is still left. So when you recalculate interest payments, they only shrink by about $.80:
[$19,800 * (.05)] / 12 = $82.50
Pay-off time: 36 years
Total interest paid: $23,091.39
However, if the person instead payed $150/month payments: after a year, about $800 of the principal balance will be paid off:
Interest : $83.33/month
Principal: $66.67/mo. * 12 months = $800
And not only will this person be paying down the principal quicker in the first place, but interest payments shrink quicker as well:
[$19,200 * (.05)] / 12 = $80.00
Pay-off time: 16 years
Total interest paid: $9254.26
Over time, the savings compounds itself as more of each payment goes towards paying off the principal balance… quicker. Also, these examples only calculate interest once a year. If interest is calculated more often, this effect is magnified.
This is why the borrower paying $100/month will take about 36 years to pay off the loan and pay an additional $23,091.39 in interest by the end. And the borrower who pays $150/month: 16 years and $9254.26 in interest.
It’s usually a wise investment to make lump payments to pay down your principal balance when you can. Because suddenly the principal balance is reduced, interest payments drop and even lower monthly payments can contribute a larger ratio of principal to interest.
Let’s say our example borrower, who can only afford $100/month loan payments is given $5,000 at graduation. What would their payment schedule look like if that money was used to pay down their $20,000 debt?
- 1st year interest payments: [$15,000 * (.05)] / 12 = $62.50
- Pay off time goes from 36 to 20 years
- Total interest savings of $14,502.83
If you do this, just make sure your extra payment goes towards the principal balance or your lender may assume otherwise.
My advice for my cousin Kyle: find a way to pay more each month. Every additional dollar he can spare each month beyond the minimum payment plan (that he currently pays) will go towards paying down the principal balance of his loan. It will mean he’ll pay it off faster, and save money on interest in the long-run.
Some of the estimates on this page were made courtesy of: Asksasha.com’s loan calculator
Image credit: Flickr