Let's say you take out a $10000 loan and make $300 payments every month for 3 years. You may notice something that doesn't seem to add up at first.  At the end of the 3 years, you will have paid $12600, even though the amount of the loan was only $10000. So what is that extra $2600? The answer is interest, the effective cost of borrowing money.  Here's how to make sense of it.

First, understand that interest is essentially the price of borrowing money and getting to pay it back later over a long period of time.  The amount of total interest you pay on a loan depends on the interest rate (which is decided by the lender), how long the borrower takes to pay back the loan (which is negotiated by the lender and the borrower), and how much you pay every month to pay off the loan (also negotiated by the borrower and lender).

A higher the interest rate, or a longer pay back period, or paying too little every month will result in a greater amount of interest on the loan.  A low interest rate, or a shorter loan period, or making bigger payments every month will result in you paying less in total interest.

Total interest is caculated as follows:  Take the $ amount of your monthly payments and multiply by the number of months in the loan period.  Then, subtract the original loan amount.  For example, if you borrow $60000 for student loans, and pay $550 every month for 10 years = 120 months, then the total interests is

($550)(120) - $60000 = $6000

Paying only $6000  for total interest on a student loan is a pretty good deal.  For a more detailed discussion of how banks actually figure your monthly payments, read the articles Calculating Fixed Rate Mortgage Payments or Computing Monthly Auto Loan Payments.  The math is slightly more complicated than the simple interest and compount interest formulas.

One way to reduce the amount of interest paid on a loan is to secure a low interest rate. Lenders look at your credit score to determine if you are a trustworthy borrower. The more trustworthy you seem, the lower your interest rate will be. If you have bad credit, the bank will offer you a high interest rate.

If you can't get a very low interest rate, the other way to reduce your interest payment is to borrow the money for a shorter length of time, that is, you negotiate to pay it back sooner. To do this, you will have to make larger monthly payments, but in the end you will pay less in total interest.