What debt actually costs

Two lenders quote on the same loan. The first wants 1,490 a month. The second wants 1,230 a month, which is 260 less and sounds like the better offer to almost everybody who hears it.

The second loan runs for fifteen years longer. Over its life it costs about 143,000 more. The monthly payment is the number that was quoted, compared and chosen on, and it is the one number in the transaction that cannot tell you what the loan costs.

Where the total comes from

Take a loan of 255,000 at 5% a year over 25 years. The payment works out at about 1,490 a month, which is a number most people can reason about.

Multiply it by 300 months and it is about 447,000. Take off the 255,000 that was borrowed and roughly 192,000 is interest — about three quarters of the loan again, handed over on top of it.

Predict

Before reading on: on that 255,000 loan at 5% over 25 years, roughly how much of the total handed over is interest rather than repayment?

Choose one answer

About 25,000About 85,000About 190,000About 520,000

Lock in answer

What an extra payment actually does

An extra amount paid into a loan does not sit in a pot somewhere. It comes straight off the outstanding balance, and interest is only ever charged on the balance. So the extra payment does not only save itself — it removes every future year of interest that would have been charged on it.

That is why small extra payments on long loans do disproportionate things to the term, and why the effect is largest at the beginning, when there are the most future years left to remove.

Property loan

≈ Hypothetical model, not a forecast

A long-dated secured loan: the payment, the interest bill, and what paying extra each month changes.

It assumes

• The rate never changes for the whole term, which almost no long loan does.
• Every payment lands in full and on time for twenty-five years.
• The lender charges nothing for repaying early, which is not universal.
• The property itself is treated as neither rising nor falling in value.

It ignores

• Purchase taxes, legal costs, survey fees and lender fees
• Insurance, maintenance, and anything else the property costs to hold
• Any change in the value of the property itself
• Rate resets, which is how most long loans actually behave

Find the smallest extra monthly payment that takes at least five years off the term. Watch the total interest figure while you do it.

Annual interest rate5%

Term25

Extra paid each month0

Paid on top of the scheduled payment, straight off the balance.

Amount borrowed

255,000

Deposit paid up front

45,000

Loan as a share of the price

0.85

Scheduled monthly payment

1,491

Total handed over, scheduled payments only

447,211

Total handed over, paying extra

447,211

Total interest, scheduled payments only

192,211

Total interest, paying extra

192,211

Months taken when paying extra

300

Months removed from the term

0

Interest avoided

0

• Balance, scheduled payments
• Balance, paying extra

◷ Not there yet — keep moving the controls.

Look at what the two lines do to each other. They start at the same place and they are almost touching for the first two or three years. The gap that eventually removes five years from the term is built almost entirely out of interest that was never charged, on amounts that were repaid early.

Check

A borrower asks to extend the same loan from 25 years to 40 to bring the monthly payment down. What happens to the two numbers?

Choose one answer

The payment falls and the total falls with itThe payment falls by a few hundred a month and the total rises by well over 100,000The payment falls and the total is unchangedBoth stay about the same, because the rate has not moved

Check answer

›Why the monthly payment became the unit of saleOptional

There is nothing sinister in it. The payment is the number that has to fit into a budget, so it is the number the borrower asks about first, and a seller who answers a different question loses the sale.

The trouble is that once payment-per-month becomes the unit, term becomes a free variable. Anything can be made affordable by making it longer, and the cost of doing so shows up in a number nobody quoted. Whenever you see a price expressed per month, the useful reflex is to ask how many months, and then multiply.

Worth remembering

• A debt has three numbers — payment, term and total — and only the last two tell you what it cost.
• Interest is charged on whatever is still outstanding, so a balance that falls slowly is charged for longer.
• Roughly: a 255,000 loan at 5% over 25 years hands over about 447,000 in total.
• An extra payment removes the balance and every future year of interest on that balance, which is why small extras remove whole years.
• Extending a term always lowers the payment and always raises the total.