It?s all in the math. Let?s take a home loan, for example. What is it
that the home buyer expects? They expect a relatively equal payment
for the life of the loan. That payment is going to consist of some
portion of interest and the rest will be principal. As you make
payments, some part in the beginning will be principal and that will
reduce your balance of course. As the balance declines, so does the
amount of interest you are charged on the loan. Recall that interest
is calculated as the balance x interest rate.
Remember what I said about equal payments through the life of the
loan? That?s important now. There are amortization functions available
to calculate what your payment would be if it were held steady. In
fact, I?m plugging in an example on my Texas Instruments BA II Plus
right now: Loan Amount = $10,000, Interest Rate is 10%, Periods is
equal to 60 (5 years x 12 months.) The monthly payment is 212.47.
But not all of that gets taken off the principal, some of it is
interest. How much? Well let?s say it is the first payment to the
bank. They receive your $212.47, they calculate interest on that by
multiplying the entire $10,000 (remember, it?s your first payment so
nothing has reduced the loan amount yet) by 10%/12 months, or a
monthly interest rate of 0.833%. That?s $83.33.
Subtract interest from the payment and you get the principal, or
$212.47 - $83.33 = $129.14. Your new balance is $10,000 - $129.14 =
$9,870.86 With that background, the answer to your question should
start to become obvious. The next month you pay $212.47 to the bank,
they check your balance, which is now $9,870.86, multiply by 0.833%
and guess what? Your interest is lower this time, it?s $82.26. Again,
subtract your interest from the monthly payment and you?ll get the
principal, or $130.21. Conversely, the portion that is principal has
gone up.
Just the numbers
====================
Loan: $10,000
Interest: 10% per annum (0.833% per month)
Periods: 60
Amortized payment: $212.47
Pmt Interest Principal Total
1 83.33 129.14 212.47
2 82.26 130.21 212.47
. . . and so on.
Summary
=======================
The reason you pay more interest up front is because you have a large
balance in the beginning. As your balance goes down, so does the
number that your interest rate is multiplied by, so your total
interest payment goes down. In the interest of keeping a steady
payment, a calculated value results from a somewhat complex
amortization formula to produce that magic number which allows you
steady payments, gives the bank its required interest, and reduces the
loan balance to exactly the number of months you require.
I trust this has answered your question. If not, let me know and I?ll clarify. |
