Is it true that interest is paid first than capital?

The interest rate of a loan, as we explained in previous posts, is nothing more than the price we pay to use that money. It is usually expressed annually, as a percentage or proportion of what we owe. For example, if your interest rate on your loan is 18%, fixed, it suggests that over the year you will pay 18 pesos for every 100 debts.

But beware! It is one thing to understand the definition and another is to understand how the interest on a loan is paid. You would only pay those 18 pesos if you pay everything in one installment, after the year of disbursement. In practice, credit agreements usually establish monthly, not annual, fees and this makes calculations a bit more complicated.

We explain it in detail

We explain it in detail

The interest you pay each month is calculated with respect to the capital you owe, not the amount you initially borrowed. After the payment of each installment, the balance due will be reduced and consequently the value at which the interest rate is equivalent, too.

In other words, in a fixed rate loan the proportion (rate) that you pay for interest will not vary, but the amount you allocate to cover those credit costs should vary. At first they will be higher and then they will be reduced.

Pay attention to the example in the table: it would be the repayment table of a loan of RD $ 100 thousand, at a rate of 18%, with one year to pay and monthly installments of RD $ 9,168.

As notes in the Interest column , the amount you allocate to this concept is decreasing to the same extent that you reduce the balance of your loan.

Also note that the $ 1,500 that you pay interest in the first month of your credit life is equivalent to 2% of the capital you owe at that time (RD $ 100 thousand), and the $ 135 you pay in the last month also equals 2% of your balance by then, which is $ 9,033.

The first months of the loan’s life a greater proportion

The first months of the loan

Since the same installment is always paid and in the first months of the loan’s life a greater proportion of it is allocated to interest, many financial users mistakenly interpret that interest is paid at the beginning.

In reality, they are paid throughout the life of the loan and, as long as the rate does not vary, they will represent the same percentage of the unusual amount we have.

In very large loans it is even possible that at the beginning one may be paying a greater proportion to the interests than to repay the capital.

Depending on the type of credit you contract and your bank’s policy, you may even have other items, such as insurance or other services you have associated with the loan, incorporated into your monthly installment.

It is always advisable to read the credit agreement well to understand in detail the payment commitments we assume. Also ask the bank for the amortization table periodically, to ensure that all payments are reflected correctly, especially when an extraordinary payment is made.

How do we make money?

How do we make money?

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