How Loan Payments Are Calculated: Amortization Explained

Most car loans, personal loans and fixed-rate mortgages are amortizing loans: you pay the same amount every month, and with the final payment the balance reaches exactly zero. The payment comes from one standard formula.

The monthly payment formula

• P is the amount borrowed (the principal).
• r is the monthly interest rate: the annual rate divided by 12, as a decimal. 6% a year is 0.06 ÷ 12 = 0.005.
• n is the number of monthly payments: 5 years is 60.

A worked example

Borrow $20,000 at 6% for 5 years, so r = 0.005 and n = 60. (1.005)^60 ≈ 1.3489, so:

Over 60 months you pay about $23,199, so the loan costs roughly $3,199 in interest.

Why early payments are mostly interest

Each month, interest is charged on the balance that's left: balance × r. In month one that's 20,000 × 0.005 = $100, so only $286.66 of your first payment reduces the debt. As the balance shrinks, the interest portion falls and more of each payment goes to principal. A table showing this month by month is called an amortization schedule.

What changes the total cost

• A longer term lowers the monthly payment but increases total interest. The same $20,000 at 6% over 7 years is about $292 a month, but around $4,540 in interest.
• A lower rate helps on both counts. Even one percentage point matters on a large loan.
• Extra payments go straight to principal (check that your lender allows them without a fee), which cuts both the interest and the term.

Credit cards work differently

Credit cards have no fixed term. If you only pay the minimum, most of the payment can go to interest and the balance falls slowly. Paying a fixed amount above the minimum each month gives you a clear payoff date.

Advertised rates may exclude fees. Compare loans by APR, which folds most fees into a single yearly rate. This guide is general information, not financial advice.