Most loans are paid off through a series of payments over a specified interval. These payments usually consist of an interest amount, computed on the unpaid balance of the loan, plus a portion of the outstanding balance of the loan, called the principal.
As we mentioned above, you can choose from various type of loans. All of these will have a different interest-principal structure and schedule. To keep it simple, this calculator focuses on the three most common groups of repayment schedules, which we will talk about below. For each repayment option, we give an example in terms of a basic loan offer (which is the default in the calculator itself). It has the following features:
- Loan amount: $10,000
- Loan term: 10years = 120periods
- Interest rate: 7.5%
- Compound frequency: monthly, with no extra repayment
- Even total payments
The majority of amortized loans operate with an even total payment schedule, which consists of a decreasing interest payment and an increasing principal payment. The reduced interest amount is balanced by an increasing amount of the principal, so that the total loan payment remains the same over the loan term.
The large unpaid principal balance at the beginning of the loan term means that most of the total repayment is the interest, with only a small portion of the principal being repaid. Since the principal amount is relatively low during the early periods, the unpaid balance of the loan decreases slowly. As the loan payback proceeds over time, the outstanding balance declines, which gradually reduces the interest payments, meaning that there is more room for the principal repayment. Consequently, this increased principal repayment increases the rate the unpaid balance declines at.
If you set the parameters according to the previously mentioned example, you can easily observe how the allocation of the principal and interest changes through the loan term in the table or chart under the main result of the computation.
As the main output shows, the monthly installment of our base loan offer is $118.7 with an even total repayment schedule. While the sum of the interest payments in the first year is $726.33, the principal part is $698.09. In the last year, however, the ratio of the yearly total principal to the interest is reversed: the principal payment increases to $1,368.2, with the interest due merely $56.22.
In this way, the total amount paid over the ten years is $14,244.21, which consists of the $10,000 principal, plus $4,244.21 in interest.
- Even principal payment
With the even principal repayment schedule, the amount of the principal is the same in every repayment. It's computed simply by dividing the amount of the original loan by the number of payments (periods). Therefore, the monthly principal in our $10,000 loan example is $10,000/120=$83.33. The amount of the outstanding balance of the loan at each payment period determines the interest payment. Since the unpaid balance decreases with each principal payment, the due interest of each payment also gradually drops. Consequently, this results in a constant decrease in total repayment (principal plus interest).
Relying on our base example, the sum of the total payments is $1,715.63 in the first year, with a relatively high $715.63 interest obligation. In the tenth year, however, the sum of total payment drops to $1,040.63, with a corresponding decrease in the interest to $40.63. The total amount paid over the ten years is $13,781.25, which consists of the $10,000 loan plus $3,781.25 in interest.
- Balloon payment
In some cases, you may choose to pay off your loan by a balloon payment at the end of a specified interval (set by the "balloon payment after.." variable. In such a schedule, the last payment equals the remaining balance of the loan plus the corresponding interest computed on the unpaid loan. Note, that before the final payment, the loan repayment structure is similar to the amortized loan with even total payments.
To give an example, if we double the loan term to 20years in our example, and set the balloon payment to occur the end of the 10thyear, the last payment is $6,824.60, with $80.56 in monthly installments. The total repayment amount is $16,453.82, with an interest payment of $6,453.82.
The balloon payment schedule might be a good option for businesses or investors with a limited payoff capacity in the early years, but a good prospect for a robust capability to repay the loan after some years. The long amortization period keeps the payments small in the early periods; the longer the loan term, the lower the monthly payments. Therefore, by setting the length of the loan's term (or in another word the amortization schedule) and the timing of the balloon payments, the loan repayment structure can be tailored to the borrower's preferences.
To get more insight into the characteristics of the above repayment schedules, it might be useful to make a brief comparison. The following table represents the summary of the main features and rounded figures of our base example in the context of the three different scenarios:
As you can see, the lowest interest payment occurs with the even principal repayment structure, which is the result of paying back more of the principal in the early monthly payments.
Logically, the best way to reduce the borrowing cost of the loan and shorten the loan repayment time is to increase the monthly installments. Any extra payment to the minimum monthly payment set by the amortization schedule directly contributes to the higher principal allocation; thus, a faster decrease in the remaining principal balance. As we have seen, a more rapid fall in the unpaid balance can lead to a significant drop in the interest, which is the prominent cost of borrowing. With our tool, you can easily study the effect of such additional payments by providing an "Extra monthly repayment".
