Two loans quoting the same rate can cost noticeably different amounts, depending on how the interest is applied.
Amortised loans
Fixed payments with interest calculated on the reducing balance.
Which front-loads the interest portion.
Daily accrual
Interest calculated each day on the outstanding balance.
Which rewards paying earlier in the cycle.
Compounding frequency
How often unpaid interest is added to the balance.
Which changes the effective rate.
Annual percentage rate
A standardised figure including certain fees.
Which allows comparison and does not capture everything.
Front-loading on amortised loans
Early payments are mostly interest and late payments mostly principal.
Which is why overpaying early has a disproportionate effect.
The same overpayment made in year one saves considerably more than in the final year.
Rule of 78 and precomputed interest
Older methods that front-load interest by formula.
Which penalise early settlement and are restricted in many jurisdictions.
Variable rates
Interest linked to a reference rate.
Which shifts the risk to the borrower.
Fees and the effective rate
Arrangement fees, insurance and administration charges.
Which raise the true cost above the quoted interest.
The comparison to make
Total amount repayable, on every option, over the same period.
Why the same rate costs different amounts
Compounding frequency, fee treatment and how payments are allocated.
Which together can produce meaningfully different totals from identical headline rates.
This is why standardised comparison figures were mandated in most markets.
Representative rates
Advertised rates offered to a defined proportion of successful applicants.
Which means many borrowers are offered something higher.
The rate you are actually offered is the only one that matters.
Fixed and variable
Certainty against exposure to rate movements.
Which is a risk decision rather than a cost decision.
Overpayment
Rights to pay early and any charges for doing so.
Which are set out in the agreement and are regulated in many jurisdictions.
A general note
This is general description of how interest calculations work; the specific terms of any agreement govern what you actually pay.
Working out what you will actually pay
Amount borrowed, term, rate and fees, run through any standard loan calculator.
Which takes a minute and removes all the guesswork.
Comparing the total repayable across options is the single most useful thing a borrower can do.
Interest-only arrangements
Payments covering interest with the principal outstanding throughout.
Which requires a plan to repay the capital at the end.
A significant number of interest-only borrowers have reached term without one.
Deferred interest offers
Interest waived if the balance clears within a period, and charged in full from the start if it does not.
Which is a materially different product from a genuine zero-rate offer.
Default interest
Higher rates applying after missed payments.
Which is set out in the agreement.
The summary
Compare totals rather than rates, understand when interest is added, and check what happens if you pay early or late.
Why overpaying early works so well
Interest is charged on the outstanding balance, so reducing it early removes interest from every subsequent period.
Which compounds in your favour.
The same amount paid in the final year removes almost no interest at all, because there is barely any left to remove.
Making overpayments count
Confirming with the lender whether the overpayment reduces the term or the payment.
Which produces very different results.
Reducing the term saves considerably more interest.
Rounding up payments
Small regular overpayments rather than occasional large ones.
Which is easier to sustain and works on the same principle.
Checking the statements
Interest charged, principal reduced and balance outstanding.
Which should be reconciled at least annually.
Where to get help that costs nothing
Most countries have free, regulated debt advice services funded by government, charity or by the creditor sector itself. They will review your whole position, explain every option available in your jurisdiction, and deal with creditors on your behalf if you ask them to.
They do not sell products, they do not charge, and they deal with situations far worse than yours every working day without judgement. The most common thing their advisers say is that people contact them years later than they should have.
Commercial firms offering the same services for a fee exist alongside them and are frequently advertised more heavily, which is the main reason many people never find the free option.
A general note
This article describes how these arrangements generally work and is not financial or legal advice. Rules, protections, terminology and available solutions differ substantially between countries and change over time, and anything with consequences for your home, your credit standing or your legal position warrants advice specific to your circumstances.
One thing worth remembering
Debt problems are experienced as personal failure and are usually the result of something ordinary: an income drop, an illness, a relationship ending, a bill that was larger than expected.
The people who resolve them are not more disciplined than everyone else. They are generally the ones who opened the letters, wrote down what was owed to whom, and asked someone for help earlier than felt comfortable.
None of those three steps costs anything, and all of them get harder the longer they are postponed.