by Louis Georges

Created on: January 14, 2009

Credit transactions have come to be the lifeblood of commerce. Wherever credit is extended, someone has incurred debt, and the management of this debt has become an issue for millions of consumers. Without good debt management, credit balances can easily spiral out of control. One of the keys to managing one's debt is to understand the manner in which interest is calculated and added to the balance.

For fully amortized loans, such as mortgages and auto loans, the calculation is done once at the beginning of the loan and the monthly payment is calculated so as to include the interest. As long as the payment is made on time, there is no necessity to recalculate the accrued interest. However, understanding the interest calculation is helpful in comprehending how each monthly payment is applied.

For a fixed-rate loan, the interest is determined by the interest rate. The interest rate tells what percentage of the outstanding balance, is to be added to the balance every year. The interest is the primary source of income for the lender.
For example, on a $100000 loan at 8%, roughly $8000 ($100000 X 8%) will be added to the balance in the first year as interest. In reality, it will be something less than $8000, because the balance will diminish with each payment made.

For fully amortized loans, the interest accrues daily. That is, the 8% per year is divided by 365, and that amount of interest is added to the balance every day. For our $100000 example, 8% divided by 365 equals 0.0002191%. 0.0002191% of $100000, or $21.91, will be added to the balance every day until a payment is made. At the end of 30 days, $21.91 X 30 = 657.30 will have been added to the balance.
On the 31st day, if the mortgage payment is applied (the payment on a 30-yr loan of $100000 at an interest rate of 8% is $666.67), the balance is reduced to $99990.63 ($100000 + $657.30 - $666.67). The cycle begins again with the 0.0002191% interest rate now applied to the $99990.63 balance.

As the balance decreases, the accrued interest becomes less every month, and more of the monthly payment is applied to the principal. This cycle continues every month for the life of the loan. Eventually, more of the payment is applied to principal than to interest. Because of this pattern, any additional payment of principal early on in the life of the loan has a significant impact, because the amount paid never accrues any more interest, allowing each future payment to pay down the balance a little bit more.

Credit card interest

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