Where your loan interest actually goes in year one

Year one barely touches the balance

Take a $200,000 loan at a 6% annual rate over 30 years. The monthly payment is $1,199.10, which most people can picture. What most people cannot picture is the split inside it during the first year.

Twelve payments, nearly $14,400 paid, and the debt has fallen by about $2,460 — around 1.2% of what you originally borrowed. More than four out of every five dollars went to interest.

This is not a trick or a bad loan. It is what the arithmetic of amortisation does, and it is the single most common reason people believe their lender is miscalculating.

Interest in any period is the outstanding balance multiplied by the periodic rate. Early on the balance is large, so the interest is large. As the balance falls, the interest share falls with it — which is why the last year of a loan is almost entirely principal.

Why the split changes as the loan ages

The payment is fixed. The interest is not. Each month, interest is charged on whatever balance remains, and whatever is left of the payment reduces the balance.

In month one of this loan, interest is $1,000 — 6% divided by twelve, applied to $200,000. That leaves $199.10 of principal. Next month interest is charged on $199,800.90 instead, so it is very slightly less, and slightly more of the payment goes to principal.

The change is tiny at first and enormous later, because it compounds. A small reduction in interest accelerates the next reduction, which is why the curve bends so sharply in the final years.

The same money over 15 years instead of 30

Here is the comparison that surprises people.

Notice how close the first-year interest figures are: $11,933 versus $11,769, a difference of under $164. Both loans start at $200,000 at 6%, so both charge roughly $1,000 of interest in month one. A shorter term does not reduce your interest in year one — the balance is the same, so the interest is the same.

What a shorter term does is pay off principal far faster, so the balance falls sooner and the total interest over the life of the loan collapses. That is where the saving lives: not in the early months, but in the years you are no longer paying interest at all, because the loan has already ended.

Comparing terms on the monthly payment alone hides the entire difference. Compare total interest paid, and total cost, or you are comparing nothing.

What this means for overpaying

An extra payment made in year one and an identical extra payment made in year twenty do not have the same effect, and the reason follows directly from the table above.

An overpayment reduces the balance immediately. That lower balance attracts less interest in every subsequent month, for the remaining life of the loan. Made in year one, the saving compounds across nearly the whole term. Made in year twenty, it compounds across a fraction of it.

So the earlier an overpayment lands, the more interest it prevents — even though the amount paid is identical and the rate never changes.

Check whether your lender applies overpayments to the balance or merely to the next scheduled payment. Applied to the next payment, an overpayment buys you a month off rather than saving interest, which is a completely different outcome.

The two numbers people forget to look at

• Total interest over the full term. This is the real price of borrowing, and it is often comparable to the amount originally borrowed.
• The balance at a fixed point — five years, say. It shows how much of the loan is genuinely behind you rather than how many payments you have made.

Payments made is a poor proxy for progress. Thirty-six payments sounds like three years of progress. On this loan, after three years the balance is still north of $195,000.

See the whole schedule, not just the payment

The Loan Calculator returns the monthly payment, the total interest over the term, and a period-by-period schedule showing how the interest and principal split shifts over time — so the year-one figures above can be checked against your own loan rather than taken on trust.

What this article is not

It is not advice about whether to borrow, or about which term is right for you. Affordability, security of income and what else the money could do are personal questions that arithmetic cannot answer. What the arithmetic does show is where the cost actually sits, so a decision made on the real numbers rather than on the monthly payment alone.