Understanding how loan repayments are calculated puts you in a far stronger position when borrowing money. Once you grasp how interest accrues and how each payment is split between interest and capital, you can make genuinely informed decisions — comparing loan offers fairly, deciding whether to overpay, and avoiding the traps that cost borrowers thousands of pounds unnecessarily.
The Loan Repayment Formula
The standard formula for equal monthly repayments (amortised loan) is:
M = P × [r(1+r)n] ÷ [(1+r)n − 1]
- M = Monthly payment
- P = Principal (loan amount)
- r = Monthly interest rate = Annual rate ÷ 12 ÷ 100
- n = Total number of monthly payments
Worked Example: Step by Step
You borrow £8,000 at 6.9% APR over 3 years (36 months).
- Monthly rate: r = 6.9 ÷ 12 ÷ 100 = 0.00575
- Number of payments: n = 36
- Calculate (1+r)n: (1.00575)36 ≈ 1.2279
- Numerator: 0.00575 × 1.2279 = 0.007060
- Denominator: 1.2279 − 1 = 0.2279
- Monthly payment: M = 8,000 × (0.007060 ÷ 0.2279) = 8,000 × 0.030978 = £247.82
Total repaid = £247.82 × 36 = £8,921.52
Total interest = £8,921.52 − £8,000 = £921.52
Understanding Amortisation
With a standard loan, each monthly payment covers interest first, then reduces the capital. In early months, most of each payment is interest. In later months, most is capital. This is called amortisation.
For Month 1 of our example:
- Interest = £8,000 × 0.00575 = £46.00
- Capital reduction = £247.82 − £46.00 = £201.82
- Remaining balance = £8,000 − £201.82 = £7,798.18
For Month 2:
- Interest = £7,798.18 × 0.00575 = £44.84
- Capital reduction = £247.82 − £44.84 = £202.98
Notice: as the balance falls, less interest accrues each month, so more of each payment chips away at the capital. This accelerates in the second half of the loan term.
APR vs Flat Rate: A Costly Confusion
When comparing loans, always use APR (Annual Percentage Rate), not the "flat rate." Car dealerships and some lenders quote flat rates, which look lower but are calculated differently.
Flat rate example: "5% flat rate" on £8,000 over 3 years = £8,000 × 5% × 3 = £1,200 interest. Monthly payment = (£8,000 + £1,200) ÷ 36 = £255.56.
This looks similar to our 6.9% APR example but is actually more expensive in APR terms — because "flat rate" interest is calculated on the full original balance throughout, not on the declining balance. The equivalent APR for this flat rate is approximately 9.5%.
Rule: Always compare loans using APR.
Early Repayment: Does It Save Money?
Early repayment of a loan saves you all future interest on the outstanding balance. If you repay our £8,000 loan after 18 months (when the balance is approximately £4,260), you save roughly 18 months of interest — about £260–£300.
However, check your loan agreement for Early Repayment Charges (ERC). Under the Consumer Credit Act 1974, these are capped at 1% of the outstanding balance if the remaining term is over 12 months, or 0.5% if under 12 months. For small loans, the ERC may partially offset your interest saving.
Comparing Two Loan Offers
Always compare the total amount repayable, not just the monthly payment or interest rate:
| Loan | Amount | APR | Term | Monthly | Total Repaid | Total Interest |
|---|---|---|---|---|---|---|
| Loan A | £5,000 | 7.9% | 3 years | £156.70 | £5,641 | £641 |
| Loan B | £5,000 | 5.9% | 5 years | £96.40 | £5,784 | £784 |
Loan B has a lower APR and lower monthly payment — but costs £143 more overall because the longer term means more interest accrues over time. If you can afford the higher monthly payment, Loan A is cheaper.
Types of Loans and Their Calculation Methods
- Personal loans: Fixed APR, fixed monthly payments — use the formula above.
- Credit cards: Variable rate, minimum payments — balance can grow despite payments if APR is high and minimum payments are low.
- Overdrafts: Usually charged as daily or monthly flat fees, or EAR (Effective Annual Rate). Convert to daily cost for comparison.
- Buy Now Pay Later (BNPL): Often 0% for the promotional period but reverts to high rates (often 29.9–39.9%) if not fully repaid in time.
Summary
Use M = P × [r(1+r)n] ÷ [(1+r)n − 1] to calculate monthly repayments. Always compare loans using APR and total amount repayable — not flat rate or monthly payment alone. Understand amortisation: early payments are mostly interest. Check ERC terms before overpaying. Our loan calculator handles all of this instantly and lets you compare scenarios side by side.