So now that you have seen how to prepare for a loan and the different types of loans you can apply for, it is time to see how you will pay back a loan. A lot of what you will pay back has to do with the amount of the principal balance and the interest.
The principal balance on a loan is either the initial amount of money that you and the lender agree must be paid back or the amount of money that is remaining to be paid back.
Meanwhile, the interest, or annual percentage rate (APR), is the amount of money that it costs to borrow the principal (the initial monetary amount). You will always end up paying back more than the principal balance on any loan.
Note that the amount of money you will have to pay in interest depends on the principal balance. What does this mean? Well, for a quick example, suppose you take out a $10,000 auto loan that has an APR of 5%. This means that every year this loan has not been fully paid off, you will have to pay an additional $500 ($10,000 \( \times \) 5%) on the loan.
With all loans, the amount you must pay back each month will depend on the principal balance and interest. This is where a payment/amortization schedule comes into play.
The payment/amortization schedule is usually in the form of a table, detailing the amount of money you must pay back on the loan each month. The table will always include the principal, balance, and interest fees for each payment period. Below is an example of an amortization schedule created from a principal balance of $25,000 with an interest rate of 8%, that needs to be paid back within 6 months from the borrowed month (in this case, April):
| Payment Date | Payment | Principal | Interest | Total Interest | Balance |
|---|---|---|---|---|---|
| May | $4,264.43 | $4,097.76 | $166.67 | $166.67 | $20,902.24 |
| June | $4,264.43 | $4,125.08 | $139.35 | $306.01 | $16,777.16 |
| July | $4,264.43 | $4,152.58 | $111.85 | $417.86 | $12,624.58 |
| August | $4,264.43 | $4,180.26 | $84.16 | $502.03 | $8,444.32 |
| September | $4,264.43 | $4,208.13 | $56.30 | $558.32 | $4,236.19 |
| October | $4,264.43 | $4,236.19 | $28.24 | $586.56 | $0.00 |
As you can see, each month's payment is itemized so you know exactly why and how much is needed to be paid for that month. These schedules are necessary so the borrower can budget appropriately for the next few months and be able to pay back their loan plus interest fees. Note that most loans with low interest fees will always be better than ones with higher fees.
Let's Practice
Look again at the amortization (payment) schedule above. Use the information displayed on the schedule to answer the following practice questions. Type in your answers to all the questions first, and then compare them to the answers displayed at the end.
1. What does not change on the payment schedule month to month?
2. How much interest will this person have to pay, in total, over the 6 months?
3. Why does the amount of interest in the Interest column decrease each month?
4. Why is the balance for September ($4,236.19) less than what must be paid ($4,264.43)?
| Your Responses | Sample Answers |
|---|---|
The amount you must pay back each month does not change. This is a key part of the schedule. The fact that you do not have to alter payments from month to month will help you budget around the loan. |
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The Total Interest column is the total amount of interest this person will be paying up to that month. Since the last month displays a total interest amount of $586.56, this is the total amount that this person will have to pay extra in interest over the 6 months. |
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Since the balance on the loan is decreasing with each payment, so will the interest on it. This will also ensure that you are paying the same amount each month. |
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The reason the balance is less is because the interest has not been added to that month. If you add the interest in October ($28.24) to the balance remaining after September, you will get the exact amount that must be paid, which is $4,264.43. |
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