In a typical loan agreement, the borrower is required to make periodic payments that cover both the principal amount borrowed and the interest that has accrued on the loan. However, in the early stages of the loan, a higher portion of each payment is applied to interest rather than principal.
This is because the lender wants to ensure that they receive compensation for the money that they have lent out before the borrower begins to pay down the principal balance. This is known as front-loading the interest.
When the borrower makes a loan payment, the payment is first applied to the accrued interest on the loan. Once the interest has been paid, any remaining portion of the payment is applied to the principal balance. Over time, as the principal balance is reduced, a higher proportion of each payment is applied to principal, and the amount of interest paid decreases.
Front-loading the interest has several benefits for lenders. It allows them to earn a return on their investment early in the life of the loan, which helps to offset the risk that the borrower may default on the loan. Additionally, front-loading the interest helps to ensure that the lender receives compensation for the time value of money - the idea that money is worth more in the present than in the future due to inflation and other factors.
For borrowers, it is important to be aware of the terms and conditions of their loan and to understand how their payments are being applied. By making regular payments and paying off their loan over time, borrowers can build a positive credit history and improve their financial health.
