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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Lots and answers. Here’s the shortest and simplest:
– Every time you pay bay a loan (a mortgage is just a loan), before you do, it has already grown by the agreed rate of growth (the interest rate).
– So $100,000 grows to say $101,000 after 1 month, but you pay back $1,200 per month. So only $200 goes to reducing the initial $100,000
Why is it like this? Because it’s the only way that make sense if you consider the following cases:
– what if you miss a payment? Well, the debt you owed still grows, but you didn’t pay some off
– what if you pay more than the agreed amount, like $2,000 say? Well, then you paid off more of the principal.
Hope that helps.
The interest is compounded monthly.
So you have a $100k loan at 5%, after the first month it compounds, meaning 100k + (100k * (.05/12)). This means after 1 months you owe $100,416.66. obviously you worked out terms of a minimum monthly payment. And it needs to be more than $416.66 for you to ever pay off the loan. So let’s say you pay $21k/year. That’s $1750/month. So after your first payment you owe $98,666.66. at the end of the second month it compounds again, so $98,666.66(1+(0.05/12)) so you owe $99,077.71. which means $411.11 is generated in interest. As you pay down the principal the amount of interest generated gets smaller. Because it’s just a % of the principal. In your case, at 5% apr, compounded monthly, you add .04% each month.
The reason making extra payments early is important is that the principal is larger, so the amount of interest generated is larger.
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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