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How Loan Interest Is Calculated

Monthly loan payments are determined by the standard amortization formula: M = P[r(1+r)^n] / [(1+r)^n - 1], where P is the loan principal, r is the monthly interest rate (annual rate / 12), and n is the total number of monthly payments.

Each monthly payment covers two parts: interest on the remaining balance and a portion that reduces the principal. In the early months, most of each payment goes toward interest. As the balance decreases, more of each payment goes toward principal. This gradual shift is called amortization.

For a $10,000 loan at 8% for 3 years, the monthly interest rate is 0.667%. The first payment of $313.36 includes $66.67 in interest and $246.69 in principal. By the final payment, nearly the entire amount goes to principal.

Personal Loan vs Auto Loan vs Mortgage

Personal loans are unsecured (no collateral), so they typically carry higher interest rates (6%–36%) but offer flexibility in how the money is used. Loan terms usually range from 1 to 7 years.

Auto loans are secured by the vehicle, which lowers the risk for lenders and typically results in lower rates (4%–12%). Terms usually range from 3 to 7 years. Longer terms mean lower payments but more total interest.

Mortgages are secured by real estate and offer the lowest rates (typically 3%–8%) with the longest terms (15–30 years). They also involve additional costs like property tax, insurance, and PMI.

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