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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The interest is usually annual, meaning that’s how much your debt grows every year. So $100k will grow to $105k, then $110,250 then $115,762.50, and so on. That is, if you don’t make any payments in the meantime. Usually loans require that you regularly make payments, and normally the payments are scheduled in such a way that you will pay off the loan in a certain period of time, say 10 years.
Now, the only way you can pay off a loan is if you pay more each year than you accumulate in interest. So for your $100k loan at 5%, you need to pay at least $5k the first year, otherwise you’ll be left with more debt than you started with. Now, of course you could compensate for that by paying more the next year, but usually the idea is that you start reducing your debt right away.
>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?
Different loans may come with different terms but AFAIK this normally isn’t the case. Ultimately, there is just debt, and every payment goes towards reducing that debt, while interest is working to increase it. But it can be helpful sometimes to think about your payments as partly paying off interest and partly paying off the principal (i.e. the original sum you borrowed). And if you think about it that way, then it is true that you first pay off the interest, because as I said above, you have to pay the interest before you can make a dent in the principal.
However, assuming that your regular payments already pay off the annual interest (and more), then any *extra* payments you make will go completely towards the principal. For instance, let’s say you paid $500 per month for the first year, for a total of $6000. That leaves you with a debt of $99k: $5000 went into interest and the remaining $1000 towards the principal. Now at the end of the year, you decide you want to pay some more: an extra $4000. That brings the principal down to $95k.
The exception would be if the terms of your loan didn’t require (perhaps in the first years) that you pay off the annual interest in full each year. E.g. let’s say your required payments only amounted to $4k, then that would leave you with a debt of $101k at the end of the year, which is more than what you started with. In that scenario, any extra payment would first go towards killing that remaining $1k in interest.
(Such terms are more risky for the lender but also carry a greater potential reward for them, since the unpaid interest compounds year-on-year; 5% of 101k is more than 5% of 100k. But of course they also want you to pay them off in the end, so they don’t want this to go on forever.)
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