If I borrow 100k at 5% interest, and to be paid back in 5 years, why is it not that case that I just pay 21k per year and would have paid 105k after 5 years? I heard that if I pay back a little extra every year, it will help to go pay off the interest first, what does that mean? If I owe a set amount of money on fixed interest, how can the total amount change?
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Interest is charged on the entire outstanding balance so when you start making payments, most of what you pay is interest with only a tiny amount paying off the loan (principal).
However, because you’ve paid off some of it, the next payment period sees you accrue a bit less interest, so the same payment pays a bit more principal than the last one did; the outstanding balance drops further.
This carries on and eventually you reach the point where you’re accruing virtually no interest and paying off the principal very quickly – right at the end of the loan term.
By making additional payments early on, therefore, you pay down the principal more quickly, thus future payment periods accrue less interest so more of your payment goes into clearing the balance.
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