Two people can make identical repayments on identical loans and end up in very different positions, purely because of when they paid extra. The reason is the principal-and-interest split, and how dramatically it shifts over a loan term.
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How the split is calculated
Each period, your lender charges interest on the current outstanding balance. Whatever is left of your repayment after covering that interest reduces the principal.
Because interest is charged on the balance, and the balance is at its highest at the very beginning, your first repayments are dominated by interest. As the balance falls, the interest charge falls with it, and a progressively larger share of the same repayment goes to principal.
What that looks like in practice
On a $600,000 loan over 30 years at 6.5%, the scheduled monthly repayment is roughly $3,790. Of that first repayment, around $3,250 is interest and only about $540 reduces the loan.
In other words, roughly 86% of your first repayment never touches the debt. It takes many years before the split reaches an even 50/50, and only in the final years does the repayment become overwhelmingly principal.
Figures are illustrative. Enter your own loan in the calculator to see your actual split period by period.
Why this makes early extra repayments so powerful
An extra dollar paid in year one removes a dollar of principal that would otherwise have accrued interest for the next 29 years. The same dollar paid in year 25 only avoids five years of interest.
This is why the timing of extra repayments matters more than the amount. A modest extra repayment made consistently from the start typically outperforms a much larger lump sum made a decade later.
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Why your balance barely moves at first
Many borrowers are dismayed to find that after a year of repayments, their balance has barely shifted. On the example above, twelve months of repayments totalling about $45,500 reduce the loan by roughly $6,700.
Nothing has gone wrong. That is simply what the amortisation curve looks like. The balance falls slowly at first and then accelerates, because every dollar of principal you remove permanently reduces all future interest charges.
Interest-only loans and the same trap
An interest-only loan takes this to its logical extreme: your repayment covers the interest and nothing else, so the balance does not reduce at all during the interest-only period.
Repayments then step up sharply when the loan converts to principal and interest, because the original principal now has to be repaid over a shorter remaining term. If you are on interest-only, it is worth modelling what your repayment becomes after the conversion.
Key takeaways
- —Interest is charged on the outstanding balance, so early repayments are mostly interest.
- —On a typical 30-year loan, the first repayment can be over 85% interest.
- —Extra repayments are dramatically more effective early, because they avoid more years of interest.
- —A slow-moving balance in the first years is normal, not a sign that something is wrong.
General information only. This guide explains how these products generally work. It does not take account of your objectives, financial situation or needs, and is not financial product advice under the Corporations Act 2001 (Cth). Figures are illustrative. Speak to a licensed financial adviser before acting.